ETFs Compared to Mutual Funds

Mutual funds were certainly a groundbreaking idea when they first emerged on the scene almost a hundred years ago. Up until then, investors who wished to purchase securities had to do so individually, and this in particular made diversification a huge challenge, where it became limited to those who had enough assets such that they could be spread around enough.

In the old days, unless you were actually present at exchanges, you couldn’t really trade securities in an effective and timely manner, and information about security prices were pretty spotty anyway. People pretty much just listened to their brokers, who preached buy and hold strategies, mostly because that was the only sensible approach at the time. This was the strategy that mutual funds ended up pursuing when they came on the scene, and this is still true for the most part all these years later.

ETFs Compared to Mutual FundsBy having investors pool their resources though, this did allow for much more diversification, as well as having one’s investments professionally managed, both of which were reserved for the wealthy up until mutual funds became widely available.

One could still enter and exit positions with mutual funds through placing buy and sell orders, but throughout its history, mutual funds have not been set up to serve the needs of those who planned on holding funds over the long term, and not for those who wished to time their positions very much.

For most if it’s history, mutual funds have been actively managed, to seek to provide better returns than the market as a whole, as a means of justifying their portfolio management over a random selection of securities. It’s focus has been primarily on stocks although you can buy mutual funds that also deal with things like bonds as well as shorter term instruments such as treasury bills and commercial paper.

Funds in general have been trending more toward passive management lately though, as a means of reducing costs and also eliminating the criticism of their underperforming the market as a whole most of the time. Given that most mutual funds do actually fall short of broad index returns, this is a move that benefits investors on the whole.

Exchange Traded Funds

Exchange traded funds, or ETFs, have emerged as a more liquid and transparent form of mutual funds, and have grown considerably in popularity since their inception in 1990. The focus with ETFs has been more on index funds, although not exclusively, as actively managed ETFs are also available, although most of the volume with ETFs are with passively managed funds that just track a benchmark.

What makes ETFs more liquid and transparent is the fact that they are traded on exchanges, right alongside stocks. In fact, to place a trade for an ETF, all one has to do is place an order through the same broker that they may place stock trades with.

Mutual funds are certainly not known for being transparent, at least compared to today’s securities markets. Back when people used to get their investment information primarily from looking at stale daily quotes in the newspaper, any information beyond that would probably have been seen as enlightening, the sort of thing you may find in a prospectus for instance.

Seeking a snapshot of what the fund holds as well as some historical performance data, their management fees, as well as their communicating the fund’s objectives, and some other miscellaneous data may impress some investors, the long term ones perhaps.

A lot of the investors of today seek to play a more active role in their investments and in particular in the decisions about when to enter and exit positions, and this is where ETFs shine. ETFs tend to consist of known baskets of securities, in a known proportion, for instance the components of the S&P 500 as an example.

More Transparency Equals More Price Efficiency

There are mutual funds that track one or more indices but they tend to track several other things as well, and their price is not particularly transparent. No one even knows what price your order will fill at when dealing with a mutual fund because the trade doesn’t take place until the end of trading, and they don’t even take trades over the last couple of hours of a market session.

Therefore, mutual funds aren’t subject to the same price discoveries and efficiencies on a moment to moment basis as is the case with actively traded ETFs. If the price deviates from the actual value of its components, arbitrageurs, who make their living taking advantage of such price inefficiencies, will swoop in and buy or sell the ETF.

This causes the price of the ETF to track what it is supposed to be tracking with greater precision and accuracy, otherwise it will be made so by this arbitrage trading. You don’t get that so much with mutual funds, since first of all they aren’t traded on exchanges like ETFs are, and secondly, no one knows what the price is at any point in time while the market is open.

While it is true that mutual funds are priced according to the net value of their holdings, and therefore while arbitrage doesn’t happen it isn’t needed, as mutual funds self-arbitrage each day, none of this is in concert with the actual value of the mutual funds shares at the point of order, and this is why they lack transparency and efficiency.

There are other reasons why it’s preferable to have the price disclosed when orders are placed to trade securities, not the least of which is that those placing the orders can act upon more accurate information, rather than just guessing or not even caring what price their orders will be filled at.

With mutual funds, the latter is most often the case, and hardly anyone who buys mutual funds is particularly concerned with this. Perhaps if you’re buying something regardless and plan on holding it for many years, none of this will matter to you, but with other types of strategies, it very well may.

If you aren’t concerned with the timing of your entry, then end of day fills may be perfectly fine. If you do care about such things though, ETFs will easily allow you to know where you entered at the time of the trade, like a stock would.

Comparison of Costs Between ETFs and Mutual Funds

Mutual funds are often sold by intermediaries, mutual fund dealers, who do benefit from these sales of course. This ends up adding to the cost of the fund. ETFs are always bought and sold by investors directly from the fund, with no third parties needing to be compensated, at least nothing that gets priced into the ETF.

The brokerage that you place your ETF trades with most certainly gets compensated, as do the market makers who operate the fund, who are the ones stocking the fund with the assets they hold.

So it’s not as if this is a complete one sided affair, and those who purchase or sell small orders will be particularly affected by this, where broker fees may consist of a high cost per order placed. This can particularly be an issue with investors who wish to invest a small amount periodically, every pay or once a month, and if you’re investing $50 a month for instance but it costs $10 in brokerage fees to place your monthly trades, that’s obviously going to be a problem.

When it comes to management fees though, ETFs do have the advantage, due to the way that they are structured. Index based ETFs boast some extremely low management fees, although you do need to account for the broker fees involved in buying and selling them.

Those who only trade infrequently will tend to benefit overall though cost wise, and those who do trade more often are going to be less likely to want to do that with a mutual fund anyway, as the difficulty in trading mutual funds combined with their penalties and other fees set up to discourage more than infrequent fund switching and trading will generally preclude much of this anyway.

On the other hand, those who wish to make frequent but smaller contributions may find mutual funds to be more suitable for them, due to not really wanting to pay brokerage costs each time they make a contribution. It’s not difficult to find a no load mutual fund where you can do this at no additional cost, which is why they are called no load.

ETFs Also Enjoy Certain Tax Advantages over Mutual Funds

When we compare overall costs of ETFs with mutual funds, we also need to account for the tax advantages that ETFs enjoy over mutual funds, due to the ways that each are structured.

With mutual funds, capital gains within the fund are generally taxable in the year that the gains were accrued, even if you have not sold the fund. This has to do with the way that mutual funds handle disbursements.

ETFs, on the other hand, are more like stocks, where investors realize capital gains or losses only when a position is closed, when the ETF is sold, or in the case of a short, when it is bought back.

Depending on one’s circumstances, it can be advantageous to defer taxes while positions in funds remain open, and if you have to pay taxes on your gains prior to that, this will mean that you are reducing the size of your portfolio by that amount essentially, because otherwise it could remain invested.

In some cases, investors may even have to sell off portions of their holding in a fund to pay the taxes due from it, instead of keeping it in. This will reduce one’s expected return provided that it is positive overall.

While ETFs do enjoy several significant advantages over mutual funds, this does not mean that mutual funds have been outdated or no longer play a meaningful role in the world of personal investment options.

It is certainly the case though that ETFs may not only provide better options for many investors who previously invested in mutual funds, ETFs have also expanded the horizon and range of fund investments to include not only buy and hold strategies but virtually any diversified investment strategy one seeks.

Ken Stephens

Chief Editor,

Ken has a way of making even the most complex of ideas in finance simple enough to understand by all and looks to take every topic to a higher level.

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