Mutual Funds. Exchange Traded Funds (ETFs). There has to be some major difference between the 2 right? I mean, after all, the finance world would never give 2 different names to the same thing, right?
When it comes down to the basic idea of the investments, they are the same. Both funds function by collecting a big pool of money and investing it across many different assets. They provide a way to invest in multiple different companies simultaneously (as opposed to a single stock). And they both aim to provide some diversification without sacrificing too much investment return. To those who are still getting their sea legs, think of it like this:
- Classic Pizza Pie (Mutual Funds) – they have been around forever, reliable, can be cheap or expensive
- Nutella Pizza Pie (ETFs) – relatively new, beloved by millennials, creative and edgy flavor combinations
Even though they have their differences, they are both still pizza. They will ravish your taste buds and fill your belly.
So to summarize, on a high-level, both investments are the same. The differences start to show when you dig into the finer details. The rest of this article will dive into those details and attempt to explain them in plain English.
Purchasing the Funds
To really understand the differences, we need to start with the purchasing process. Mutual funds can only be purchased when the stock market is closed. Conversely, ETFs can only be purchased when the stock market is open.
A good analogy here is sports betting. If you want to bet on a game, you need to put your bet in before the game starts. The mutual fund is your bet and the game is the stock market. Once the stock market opens and stock prices start moving up and down, you can no longer bet. Therefore, you must place your bet (buy the mutual fund) at some point before the game begins (stock market opens for the day). In practice, this means mutual funds are usually bought at the end of the day when the market is closed (after 4pm EST).
An ETF on the other hand, is like live sports betting. You wait until the game has begun (stock market opens) and then you place your bet (buy an ETF). Live betting is relatively new and came into existence due to improved technology and computing power. The same could be said about ETFs.
Both mutual funds and exchange-traded funds (ETFs) can be divided into two broad categories, Active and Passive.
Actively managed funds have someone pulling the strings and trying to beat the market return. They will constantly buy and sell shares in companies and change the overall makeup of the fund with the goal of achieving better returns. In other words, it is like a basketball coach trying to make his team play better by substituting players every 2 minutes.
On the flip side, passive funds will play the same 5 players the entire game and stick to their strategy. Index funds are a part of the passive family. They simply try to replicate an index such as the S&P 500. In other words, the coach will play the same 5 players all game and won’t think too hard about strategy. Instead, he/she will simply look at what another coach is doing and try to replicate that strategy.
Each type of fund incurs expenses and like any good financial product, the fees can have about 100 different names. Rather than wasting everyone’s time trying to explain every fee you may encounter; I will group all the fees into two major classes. Essentially I will focus on the two major branches of the tree, rather than every individual leaf that grows off it:
- One-Off Expense: this fee is only paid when you buy or sell the fund. Think of it as a sales commission that you always pay, regardless if you are the buyer or the seller, nice right? It is often referred to as a “load” in the world of mutual funds. No-load mutual funds and commission-free ETFs essentially waive this fee, however, it often comes coupled with a higher expense ratio…
- Ongoing Expenses: this is meant to cover the ongoing expenses of running a fund. The people in charge of managing the funds have offices and salaries. They are not going to invest your money for you without taking a cut. These expenses are often summed up by something called the expense ratio and it is extremely important. If a fund delivers a 15% return, but has a 10% expense ratio, then guess what? You’re only getting a 5% return.
Actively managed funds will have higher expense ratios. This is true for both mutual fund and ETFs. And this makes sense. If a fund manager is constantly monitoring and analyzing the fund’s performance, he/she is going to expect compensation. Passive mutual funds and index funds will have lower expense ratios. In general, the more actively managed or niche a fund is, the higher the expense ratio will be.
Accessing the Niches
ETFs have exploded in popularity in recent years. There is an ETF for almost every type of niche. For example, want to buy a collection of Chinese companies who primarily focus on the production of teddy bears? There is probably an ETF for that. Okay maybe that example was a bit exaggerated, but you get the point. ETFs allow you to access specific subsegments that may not be possible with other investments.
Mutual funds will not offer as much specialization and tend to be more diversified. Index funds replicate an index, so if there is not a Chinese teddy bear manufacturing index, then there will not be an index fund for this niche.
A word of caution, the more specific and unique an ETF is, the greater the risk of tracking error. Let’s jump back to the teddy bear example above. You believe that the demand for teddy bears from China is going to explode in the upcoming holiday season. So, you buy an ETF named “Chinese Teddy Bear ETF”, which aims to capture the demand of the teddy bear market. The ETF may try to accomplish this by purchasing shares in the 5 largest Chinese teddy bear manufacturers. Now imagine the holiday season comes and the demand for teddy bears is booming.
There is no guarantee that your investment will also skyrocket. The increased demand may be absorbed by a new Chinese teddy bear company that is not in your ETF. This mismatch between what an ETF aims to track (demand of Chinese teddy bears), and the benchmark (actual demand of Chinese teddy bears) can be thought of as tracking error.
This is a dense subject. You can find entire books written about all the ways mutual funds and ETFs differ from a tax perspective. Both funds are subject to the same capital gains and dividend tax. The differences really start to show when you look at the actual process behind the purchase/sale of shares and the turnover of companies within the fund. Rather than diving down this rabbit hole, I’ll leave you with this one sentence summary: actively managed funds to be less tax efficient than passive funds.
ETFs disclose their holdings daily, while mutual funds do so quarterly or semi-annually. In English: ETFs tell you which companies they are holding and how much of each on a daily basis. Mutual funds only tell you this information at certain times during the year.
Which is right for me?
Both. A pillar of any good investment strategy is diversification. This applies to the investment vehicle as well. By utilizing mutual funds and ETFs together, you maximize your investment options. Using an aggregator tool like Personal Capital will help you see how your investments fit together and the allocation of your overall portfolio.
Now there is something to be said about simplicity here as well. Don’t spread your money over 100 different investments just to ensure that you have an equal number of mutual funds and ETFs. Instead keep it simple. Find low cost (commission and expense ratio) investments that aim to replicate the return of the overall stock market. Do not try to buy fancy funds and ETFs which aim to beat the market. The majority of them will fall short in the long run. With investing, the old adage rings true: “slow and steady wins the race”.