ETFs & Mutual Funds - The Basics
What are some of the differences and why should the individual investor actually care?
Exchanges Traded Funds (ETFs) and mutual funds make up more and more of the global investment landscape. Therefore, they continue to be an increasingly common piece of individual investor’s portfolio with each passing year. To many these investment products are interchangeable and do not present any real discernible differences. ETFs and mutual funds often serve a similar purpose, are issued by similar fund companies, and many times might have similar strategies. To the individual investor, however there are important differences that make the use of one or the other more appropriate depending on the situation.
what is an etf? what is a mutual fund?
An ETF is a fund created as a basket of investment securities which trades directly on the open market in a similar manner that a stock or bond might. It is commonly created to track an underlying index in a passive manner (though not always). It’s value to an investor is determined by the pricing of any underlying securities it owns, in addition to supply and demand and other volume or liquidity factors throughout the market’s trading day. An investor investing in an ETF is buying shares of the ETF itself which may represent hundreds of underlying securities. Through one share of an ETF, an investor is generally able to obtain better diversification benefits than they ever could buying one share of any single company. ETFs are typically governed by the Investment Company Act of 1940 or associated regulations.
A typical open-end Mutual Fund however is a fund holding underlying securities, but purchased directly from the fund company itself - not on the open market - most commonly either independently or through a financial advisor or broker. Shares of a fund are therefore subscribed to and redeemed from the fund company directly. They are not traded on an open market with other willing buyers and sellers. The value of a mutual fund is determined once per day based on the total value of the underlying companies. Closed-end Mutual Funds are a different consideration and are a topic of discussion separate from this article. Mutual funds are also typically governed by similar laws and regulations as that which govern ETFs.
If you’re not entirely clear still on the key differences between the two and when one may make sense over the other - you’re not alone. These investment options are similar in a general sense, but if we consider certain scenarios and discuss the basic benefits and drawbacks of each we can gain a more informed understanding.
benefits of ETFs
Perhaps the most apparent benefit to ETF investing over Mutual Funds are the built-in tax efficiencies. ETFs, due to their structure, are able to utilize strategies called “creation”, “redemption” and “in-kind transfers” which minimize tax friction when investors look to enter or exit an ETF. When an investor buys an ETF during a trading day, the ETF is able to create necessary shares by acquiring additional underlying holdings from counter-parties to meet the demand. Further, when investors sell their shares the ETF may transfer holdings in-kind to counter parties in exchange for necessary liquidity, but at not tax cost. There are other unique considerations however, this general level of broadly diversified tax-efficiency is a trademark of ETFs.
Since ETFs trade during open market hours, investors are able to capture current pricing that is representative of actual activity as it occurs throughout a trading session. In the largest and most heavily-traded ETFs this is quite helpful for an investor to insure they are acquiring or disposing of shares of a given ETF at the price they desired. Careful consideration should be made however to ensure the pricing is indeed what you desire, as the price may move constantly during market hours and the value can change at a moment’s notice.
ETFs tend to be a low-cost investment option. While mutual funds can also present low-cost options, ETF’s given their lower-overheard and internal costs can typically offer a cheaper alternative to their Mutual Fund equivalent. In some investment strategies, cost can be king and if choosing between two apparently identical ETFs and mutual funds - going with the cheaper option can be the determining factor.
Unlike many mutual funds, ETFs typically do not require a minimum level of investment. Mutual funds through retirement plans often may not have minimums as well, but ETFs are almost exclusively minimum-free. Mutual funds may require a few thousand dollar minimum investment, whereas for certain institutional share classes a fund may require an initial investment of $100,000 or greater.
Concerns of ETFs
Volume & Pricing Considerations
Since ETFs trade during open trading hours and on existing markets, they are bound somewhat by traditional supply and demand economics. To fulfill an order to buy or sell, there needs to be adequate buyers and sellers to create sufficient liquidity and volume to meet an order at the desired price. If the ETF is not widely traded and has insufficient volume, pricing spreads and disparities can widen as shares are created, redeemed and transferred. Use of a basic market order to transact in an ETF can result in a broad range of potential outcomes.
A better solution - all things being equal to consider ETFs that have higher volume in order to attain more accurate and certain pricing. If the ETF is rare or uncommon but still desirable to transact in, use of a limit order and tight professional management can be a more prudent approach. Additionally, even for liquid markets and widely-traded ETFs, it is wise to engage in the trading activity while the underlying market is open.
Variability due to Institutional Transactions
As many ETFs are passive in nature, meaning the underlying basket of securities are largely left untouched and follow the movement of their market index, timing of when sales occur during a day can have a significant impact on the price. Institutions and market makers often systematically transact around the opening and closing bells of many markets in which they participate. These high-volume times of day can have a large impact on prices.
Since ETFs trade like any other publicly traded security, there is typically a commission charged by the broker-dealer doing the buying or selling. While these commissions are typically immaterial on a standalone basis, when a high volume of trading activity occurs within an investor’s portfolio, the costs can become more a drag on long-term portfolio appreciation. While the internal costs of an ETF can be cheaper than their Mutual Fund counterparts, this is not necessarily true for the cost to transact. Like anything, there are exceptions and investors should perform their own diligence over transaction costs.
benefits of Mutual Funds
Mutual funds can offer very similar results to an ETF but through a traditional fund structure with more predictable pricing. Unlike an ETF, a mutual fund is purchased directly from the issuing fund company and trades at it’s net asset value - a known and static amount. The net asset value is the entire asset value of all of the shares the mutual fund holds divided by the number of fund shares. This net asset value is determined on a daily basis by the fund company and is the price at which shares of the fund can be subscribed to until the next daily net asset value is determined. To some it will make sense knowing exactly what you are paying for or will receive when it comes time to buy or sell - especially if a large amount is involved.
Tactical Approaches & Professional Oversight
Investors that desire tactical and active approaches to managing investments will likely find more attractive options in the Mutual Fund space. There are other options for those interested in active management, but the mutual fund space typically has more options and resources dedicated to actively managing a portfolio than their ETF counterparts. In certain, less voluminous areas of the market and in alternative strategies turning to a mutual fund can be preferred to being in an overly passive ETF.
Flexible Transaction Cost Options
While ETFs typically are associated with transactions fees, many Mutual Funds offer several different share classes with varying associated costs. A, B and C Shares that are typically acquired from a broker who earns a commission from a fund company to sell their products are not the choice that Hudson Oak Wealth Advisory would traditionally recommend. There are however many investor level or institutional level share classes available through Hudson Oak or within retirement plans that have no transaction costs associated with them at all. Often times, even with some retail brokerage accounts investors can acquire mutual funds without a transaction cost - though they may only be that company’s proprietary product.
concerns of Mutual Funds
One of the largest concerns of investing in a mutual fund is how inefficient certain funds can be from a tax perspective. This is because, unlike the ETF structure of acquiring or disposing shares through creation or in-kind transfers and over an open market, mutual fund investors subscribe and redeem directly from the fund itself. The way a mutual fund is structured, in order to provide redeeming shareholders with cash, the fund must first have the cash available. If a fund does not have ample cash, it must sell underlying securities within the fund to create the cash. In some cases, these sales can create taxable gains. By law, a mutual fund must distribute a certain portion of it’s income each year to underlying shareholders. Therefore, if a fund experienced redemptions during the year, it may have to distribute capital gains, which flow to underlying shareholders and can lead to an unexpected tax liability for the individual investor.
Higher Internal Costs
Mutual funds can have higher operating costs than their ETF counterparts. Therefore, the product costs can be higher as well. In some cases, these costs are justifiable, in many other cases however, if the investment strategy and composition between an ETF and mutual fund are essentially identical - the ETF’s lower cost can be the determining factor. In more nuanced, less common investment strategies, sometimes the higher cost of a mutual fund can be worthwhile if it provides an investor with added diversification, alternative return streams, or superior investment returns not available through a comparable ETF.
This list of considerations of the pros and cons of ETFs and mutual funds is not all-inclusive and there are many other factors an individual investor should consider before investing. Therefore, careful consideration and planning should occur before choosing how to best invest your capital. At Hudson Oak Wealth Advisory we understand the complexities involved with the investments that we recommend our clients invest their money in. We possess the expertise to understand how, when and where to invest in these products. As Fee-Only advisors, we are product agnostic as we are never compensated to have a client invest in one option versus another since we do not sell financial products. We are Fee-Only fiduciaries.
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