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Mutual Funds vs. ETFs

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Mutual funds and exchange traded funds are two types of investment funds available to investors. Both types of funds pool capital from lots of investors, and both are professionally managed. There are a few other similarities, and quite a few fundamental differences.

Before deciding between the two, it’s important to understand the differences and objectives of each type of fund.

Similarities between Mutual Funds and ETFs

As mentioned, both mutual funds and exchange traded funds pool savings from multiple investors. This means investors benefit from economies of scale. Fixed costs are spread across the entire fund, reducing the burden on each individual investor. Variable costs are also reduced as funds typically pay wholesale fees for trading and administration.

The economies of scale also allow for funds to be managed by investment professionals. Unless an individual has a very large stock portfolio it would be very expensive to have the portfolio managed by an investment professional. By contrast, ETFs and mutual funds both give investors access to professionally managed portfolios for less than 1% of the value of assets each year.

Most investment funds offer diversification regardless of their structure. For a portfolio to be diversified, it needs to include 15 or more securities. Most mutual funds hold at least 30 different securities, while the average ETF is even more diversified. There are some exceptions though – the SPDR Gold Trust, an ETF, only holds physical gold and offers no diversification.

Indexes play a role in the management of both mutual funds and ETFs – however, ETFs track the index while mutual funds use the index as a benchmark against which performance is measured.

Differences between Mutual Funds and ETFs

Mutual Funds and ETFs are unique legal structures, and both are regulated. Mutual funds have been around since 1924, while ETFs have existed since 1993. In the US both are regulated by the SEC (Securities and Exchange Commission) and legislation which is updated from time to time. Similar regulatory bodies oversee funds in other countries.

Active vs. Passive Management

While both types of funds have different legal structures, the most fundamental difference lies in the way they are managed.

Market outperformance is known as alpha, while the performance of the market (or an index) is known as beta. The objective of actively managed funds is to earn both alpha and beta by outperforming an index. The objective of passively managed funds is to earn beta by tracking the index.

Asset management companies manage actively managed funds. A fund manager will have overall responsibility for each fund but will be supported by a team of analysts. These analysts conduct ‘bottom up’ research on individual securities. Together the team attempts to generate alpha by deciding which securities to buy and sell, and when to do so.

Smaller teams manage passive funds, and the fund managers and analysts often have a background in quantitative analysis. The objective of a passive fund is to mirror the performance of an index by holding securities in exactly the same proportion as that index. Changes to the fund’s allocation are only made when changes are made to the index.

The vast majority of mutual funds are actively managed – though some are passively managed. By contrast, the vast majority of ETFs are passively managed. Actively managed ETFs have been allowed in the US since 2008, but still account for small percentage of funds.

The implication of the different management styles is that if you invest in a mutual fund you are expecting to earn alpha and beta, while you would only expect to earn beta from an ETF.

Expense Ratios (Mutual Funds vs ETFs)

Fund management companies charge various fees to cover management and operational costs. These fees are reported as expense ratios, which reflect all fees charged each year, expressed as a percentage of the fund’s value.

Mutual funds charge substantially higher fees (on average) than ETFs. Expense ratios for mutual funds average around 0.65%, though they do vary considerably. Expense ratios for ETFs average around 0.2%, but also vary. Expense ratios for both can be as high as 2% for very specialized funds.

The reason for the difference in fees is that active management requires more manpower. As many as 30 analysts may contribute to the management of a mutual fund. On the other hand, just two or three people manage some ETFs.

Mutual funds justify the higher fees because they attempt to earn alpha as well as beta. However, there is no guarantee that a mutual fund will earn alpha. In fact, if a fund underperforms its benchmark, it is not even earning beta, and the cost is effectively higher.

Pricing (Mutual Funds vs ETFs)

When you buy an ETF, you are buying shares that already exist. For mutual funds the process is a little different. When you ‘buy’ mutual funds you are in fact investing in new units that are created. When you ‘sell’ your unit trust you redeem the units and receive their value in return.

Both mutual funds and ETFs have a net asset value (NAV) per unit or share. This is the value of all assets held by the fund divided by the number of units (mutual funds) or shares (ETFs).

Although the NAV of a mutual fund changes throughout the day, it is only reported once each day. New investments and redemptions are based on the daily NAV. Some mutual funds charge an upfront commission, though this is less common than it used to be.

ETFs are listed instruments just like the shares of publicly listed companies. When you buy and sell ETFs you pay commission to a broker. The price at which you buy and sell an ETF depends on supply and demand.  When you buy an ETF you pay the higher offer price, and when you sell it you receive the lower bid price. The bid-offer spread is therefore an additional expense for ETF investors.

In practice, the bid and offer price is usually quite close to the fund’s NAV. Authorized Participants and arbitragers can make a profit if the bid or offer price varies much from the NAV – and their actions keep the market price in line with the NAV. However, if a fund holds illiquid instruments or there is little liquidity in the fund itself, the price can stray further from the NAV.

The difference in the way mutual funds and ETFs are prices and traded means ETFs can be traded intraday. On the other hand, there is only one daily price for mutual fund transactions.

Fund Class

Mutual funds often have various classes of units. Accumulation units reinvest any dividends and other income. Distribution units pass income and dividends on to investors. Some funds also have different classes for different investors and fee structures.

Some ETFs are divided by class, but for the most part, there is only one class of share for an ETF.

Tax

Both mutual funds and ETFs are more tax-efficient than owning a portfolio of securities. However, for mutual funds, large withdrawals can sometimes result in taxable capital gains distributions. This makes ETFs slightly more efficient from a tax perspective. Note: This can vary from one jurisdiction to another.

Minimum Investment Amounts

The minimum you can invest in an ETF is the price of one share. In the case of mutual funds, each class of fund has a minimum amount that can be invested, either with a scheduled debit order or as a lump sum. In many cases, the minimum investment is relatively low, while in others it can be $10,000 or higher.

Mutual funds do offer the advantage of regular automated purchases by debit order, which is not always available to ETF investors.

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Mutual Funds vs. ETFs

Conclusion

Twenty years ago, mutual funds dominated the fund management industry. As of 2020, savings held in ETFs is roughly equal to that of mutual funds, with the bulk of new investments going into ETFs.

This doesn’t necessarily mean ETFs are better, but in many cases, ETFs do serve their purpose better. Ultimately, deciding between the two comes down to your objectives as an investor, the objectives of a fund, and how likely a fund is to achieve its objectives.

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Richard Bowman is a writer, analyst and investor based in Cape Town, South Africa. He has over 18 years’ experience in asset management, stockbroking, financial media and systematic trading. Richard combines fundamental, quantitative and technical analysis with a dash of common sense.

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