Exchange traded funds vs mutual funds
Exchange traded funds vs mutual funds
How are ETF’s and mutual funds different?
One of the hallmarks of modern investing is the (relatively) safe and consistent growth available by purchasing “baskets of stocks” in a mutual fund. Individual stocks can be extremely volatile with high risks that are not necessarily suitable for long-term investing and retirement planning. Most investors pay a small fee to fund managers for the privilege of getting access to hundreds or thousands of stocks in one fund, which allows them to grow their wealth as the overall stock market rises, without the risk of one company going bankrupt or having poor earnings.
Both ETF’s and mutual funds hold “baskets of stocks”, and in most cases are similar in terms of their performance. An S&P 500 ETF and an S&P 500 mutual fund track the same index and will (for the most part), have identical performance over time.
However, there are some minor differences that in our opinion make ETF’s superior for retail investors. Both ETF’s and mutual funds are containers that hold many different types of stocks within them, but those containers are different from each other.
Transparency
ETF’s tend to be more open and transparent in their holdings than similar (or identical) mutual funds. Many funds have a history of trying to obscure to their investors what stocks they are holding. Mutual funds only have to disclose their holdings every quarter, which means the contents can “drift” during the quarter, without investors knowing what the fund is actually holding. Most ETF’s publicly disclose their holdings on the funds website daily. Even for those that don’t publicly disclose, those issuers still need to publish the lists of what securities an authorized participant (AP) must deliver to the ETF to create new shares, as well as what shares they’ll get if they redeem shares from the ETF. So even if they don’t publicly disclose the data, it is still available. Actively managed ETF funds are required by law to disclose their portfolio holdings on a daily basis, making them extremely transparent.
In short, mutual funds can hide their holdings and ETF issuers cannot. This is a big win for investors.
Tax Efficiency
ETF’s are much more tax efficient than mutual funds, which means investors are going to pay less taxes while holding an ETF version of an identical mutual fund. Within any fund, the portfolio managers are going to buying and selling stock. If it’s actively managed, they are doing this to maximize their performance. However, even if the fund is just tracking an index (S&P 500, Dow Jones Industrial Average etc.), the fund is regularly rebalancing to track the index, or to meet redemptions for shareholders.
When the fund sells a stock that has increased in value, it “locks in” the capital gain. By law, that gain has to be dispersed to the shareholders by the end of the year. Therefore, the owners of those shares (you) need to pay taxes on that distribution. Imagine having to pay taxes on a mutual fund distribution on a fund that has lost value the past year! It can feel like a smack in the face on top the already poor performance of the fund that year.
ETF’s get around this in a variety of ways. See the figure on the percentage of funds that paid a capital gain from Morningstar in 2018. Generally speaking, a large number of ETF’s track indexes, which means they are actively buying and selling less during the year than many actively managed mutual funds. This fact alone, makes index based ETF’s far more tax efficient for the average investor.
ETF’s also create and redeem shares differently than mutual funds, leading to even more tax efficiency. When a mutual fund investor puts in a sell order, the mutual fund must sell their stock to raise money to satisfy that request. But when an investor wants to sell shares of an ETF, the fund just sells the shares to another investor like a stock. ETF funds uses “authorized participants” (AP), which are large financial institutions that acquire the securities the fund needs to purchase to maintain an index. When the AP redeems the shares, the ETF fund doesn’t immediately sell stocks to pay the AP. Instead, the issuer simply delivers the underlying holdings of the ETF itself. This means there is no sale, and therefore no capital gains will be distributed to the shareholders. Fixed income ETF’s do tend to be less tax efficient than pure index ETF’s, which means there will likely be some capital gains distributions, but still less than comparable mutual funds.
Percentage of ETF’s and mutual funds that paid a capital gains distribution- Morningstar 12/18
More Trading Control
When an investor puts in a buy order for shares of a mutual fund they are making an obligation to purchase that fund at its net asset value (NAV) price at the close of the trading day. Think about what that means. The investor literally has no idea what price they are going to ultimately pay for their product, and it can vary widely by the time the shares are purchased. In what other industry to people pay an unknown amount for a product? ETFs solve this problem because they trade on an exchange all throughout the day, similar to an individual stock. This allows the investor to have more on control on the price they pay, and also allows them additional options like setting stop losses, trading derivatives on ETF’s and a variety of other functions that normally are reserved for stocks.