If you are new to investing, it is easy to become overwhelmed. ETFs, mutual funds, IRAs, expense ratios, time value of money, etc. They are all important concepts. But like anything else in life, it takes time and effort to truly understand and appreciate them.
Today, we will be going over the differences between ETFs (exchange-traded funds) and mutual funds. They are very similar as they are both investment vehicles, but yet they have very different characteristics.
Both mutual and exchange-traded funds share a basic structure. Consider the fund as a vehicle, one that owns many distinct stocks, bonds, or other types of financial securities. Each mutual fund or ETF has a style of investing or objective.
Both ETFs and mutual funds come in many varieties. Two broad categories include actively managed and passively managed funds. Passively managed index funds mirror the investments in an index like the S&P 500, while actively managed fund managers buy and sell financial assets and try to beat index returns.
What is a Mutual Fund?
On March 21, 1924, Edward G. Leffler launched the Massachusetts Investors Trust, the first mutual fund. Prior to this offering, investors who wanted a diversified investment portfolio had to buy shares of individual stock and/or bond, resulting in expensive commissions. This was truly the first way to efficiently invest in multiple securities without having to purchase them directly.
Mutual fund features:
- Investors’ funds are pooled together to invest in a fund with a predetermined objective. The objective might be to outperform the S&P 500, Russell 2000, provide income via dividend stocks, etc. The possibilities are endless.
- Mutual funds charge management fees typically levied as a percent of the assets under management (AUM). There are also 12b-1 fees, which are kickbacks to the selling broker. Read more on the importance of working with a fiduciary financial advisor.
- Some mutual funds also charge commissions or loads when bought and/or sold.
- Mutual funds can be purchased by financial advisors or by individuals through an investment firm such as Fidelity, Schwab, TD Ameritrade, or Vanguard.
- The price of a mutual fund is the net asset value (NAV) or value of the underlying securities, less operating expenses divided by the total number of shares. Net asset value = (market value of assets – liabilities)/shares outstanding
- The funds are priced and traded once daily after the market closes at 4:00 PM EST.
The 2018 Investment Company Institute Factbook estimates that 100 million American’s owned mutual funds in mid-2017 (date of the most recent data). At the end of 2017, it is estimated that there were 9,356 mutual funds, down from a 2015 peak of 9,517.
Exchange traded funds or ETFs are newer than mutual funds and have distinct features.
What is an ETF (Exchange Traded Fund)?
An ETF is like a mutual fund in that many investors pool their money, which is then managed by a firm that buys financial assets according to the objective of the fund. The first ETF was created in 1990 in Canada. Three years later, the Securities and Exchange Commission (SEC) approved the first ETF in the U.S. in 1993. Until 2008, the only ETFs that were permitted were those that mirrored specific indexes, like the S&P 500, DOW, or NASDAQ Composite. Recently, actively managed ETFs were allowed.
- Shares of an ETF can be bought and sold throughout the day on a stock exchange at a market-determined price. Shares are bought through a brokerage account and trade like a stock.
- Most ETFs are structured as open-end investment companies, like mutual funds and are governed by the same laws.
- ETF prices are determined by the buyers and sellers on the investment exchange and might not equal the net asset value (NAV) of the underlying investments. Thus, ETFs may sell at a discount or premium to NAV.
- ETFs also levy fund management expense ratios, like mutual funds, although the ETF management fees are typically lower than those of mutual funds.
- When buying or selling an ETF, investors may be required to pay a commission, like when trading stock. Although several firms offer commission-free ETF trading for a limited number of funds.
The US ETF market is pegged at 1,832 funds and $3.4 trillion in total net assets at the end of 2017, according to the 2018 Investment Company Institute Factbook. This is a massive increase from 1999, where there were only 30 ETFs in the market. Unlike mutual funds, ETFs continue to grow rapidly each year.
What do ETFs and Mutual Funds Invest In?
ETFs and mutual funds invest in a wide range of financial assets, including:
- Real estate (REITS)
There’s an ETF or mutual fund for every type of investor from the market matching index fund such as the Vanguard Total Stock Market ETF (VTI) to the long/short strategy-focused JPMorgan Hedged Equity A (JHQAX).
But just because a fund is available, doesn’t it make it right for your investment portfolio.
That’s where a well-educated San Diego Financial Planner can help choose the appropriate funds for your situation. Market matching index funds tend to outperform actively managed funds by a wide margin over time. So, it’s wise to choose an advisor who understands the best investment strategies.
According to ETFtrends.com, the most popular ETFs include:
- SPDR S&P 500 (SPY)
- PowerShares QQQ (QQQ)
- SPDR Gold Shares (GLD)
- iShares MSCI Emerging Markets (EEM)
- Vanguard Total Stock Market (VTI)
- Vanguard FTSE Developed Markets (VEA)
- Financial Select Sector Fund SPDR (XLF)
Notice that most of these ETFs mirror broadly diversified investment indices. This is true for the vast majority of ETFs. Represented are the S&P 500 (SPY), the Nasdaq Composite (QQQ), the MSCI Emerging Market Index (EEM), and the total stock market index (VTI). Peppered in with the most popular ETFs are several sector funds, indicating investors beliefs that specific market sectors will outperform the broad markets. Unlike the S&P 500 or total market index, a sector fund has a more narrow focus.
ETFs go beyond index investing. Strategy focused ETFs attempt to buy and sell specific assets and derivatives in an effort to beat the market returns. These alpha-seeking ETFs include:
- Innovator S&P 500 Power Buffer ETF (PAPR)
- Strategy Shares U.S. Market Rotation Strategy ETF (HUSE)
- TrimTabs All Cap U.S. Free-Cash-Flow ETF (TTAC)
In most cases, it’s best to leave the niche strategy funds to speculators and professional investors.
Popular Mutual Funds
Many funds are offered in both a mutual and exchange-traded form. This gives investors a choice to either trade the fund ETF or to own the mutual fund in a 401(k) or another investment account.
According to MarketWatch many of the most popular mutual funds represent similar indices such as the S&P 500 and total stock market.
Popular Mutual Funds: (according to https://www.marketwatch.com/tools/mutual-fund/top25largest)
- Fidelity 500 Index Fund (FXAIX)
- Vanguard Total Stock Market Index Fund Admiral Shares (VTSAX)
- Fidelity Cash Reserves (FDRXX)
- Vanguard Total Bond Market II Index Fund Investor Shares (VTBIX)
- Fidelity Contrafund Fund (FCNTX)
- American Funds The Growth Fund of America Class A (AGTHX)
Popular mutual funds also span the index fund category while including several actively managed funds by Fidelity and American Funds.
Just because a fund is large and has many assets under management, doesn’t mean it’s the best fund for your goals and situation.
What’s an Exchange Traded Note (ETN)
Frequently (but mistakenly) ETNs are lumped together with ETFs. ETNs are debt instruments issued by a bank or investment company.
ETNs are unique in that unlike a bond, which is a loan, an ETN’s return is linked to another asset, typically a benchmark index. In fact, an ETN’s return can be linked to the price of gold, options, commodities, various indexes, and more.
Created in 2006, ETNs give investors access to previously inaccessible corners of the market, particularly within the currency and commodity asset classes.
Popular ETNs include:
- iPath Dow Jones-UBS Commodity Index Total Return ETN (DJP)
- iPath MSCI India ETN (INP)
- iPath S&P 500 VIX Short-Term Futures ETN (VXX)
- JP Morgan Alerian MLP Index Exchange Traded Notes (AMJ)
- iPath S&P GSCI Crude Oil Total Return Index ETN (OIL)
Like most financial assets, ETN values will vary and are influenced by the creditworthiness of the ETN-issuing bank.
Most long-term investors can prosper without including ETN’s in their portfolios. ETNs are riskier and are less liquid than typical ETFs and mutual funds.
Why I Invest in ETFs instead of Mutual Funds
When I constructed Bull Oak’s investment portfolios, I set out to create an unbiased portfolio that would help my clients reach their overall goals. Read more on our investment philosophy to learn more about our process.
In choosing an investment portfolio, I create an asset mix that is appropriate for the investor and his or her family. Our studied risk process helps to take advantage of periodic mispricing in the markets.
When choosing funds, I’m not loyal to a specific fund provider, but examine the expense ratio, tracking error, and liquidity. That’s where my education and experience benefit you.
We typically use ETFs instead of mutual funds due to their low expense ratios, liquidity, and increased trading windows. For the types of portfolios we design, ETFs are the better option.
The expense ratio of a fund is of the utmost importance. Many index funds are clones of one another, with the main distinction being the management fee. Thus, as long as the tracking error (more about this next) is negligible, I’ll choose the fund with the lowest fee, to ensure more of your money goes into the investment markets.
After assessing the best mix of investments, I make certain that the index funds selected are closely replicating their underlying indices or have a low tracking error.
For instance, one of our core holdings is the iShares Core S&P 500 (IVV).
The tracking error describes how closely the fund replicates the index, before fees. The lower the tracking error, the better. The tracking error for IVV is only .05%, pitting as one the best within the ETF universe.
The IVV expense ratio is .04% which means for a $100,000 investment, the fund charges only $40 annually to govern and manage IVV. This management expense ratio goes directly to the fund manager, not the brokerage firm or the investment advisor.
Furthermore, be sure that the ETF you are considering is liquid. There needs to be enough shares trading every day so that it is easy to buy and sell the security. This means there is minimal spread between the buyer and sellers pricing.
Finally, when you are considering whether or not to purchase a specific security, be sure that the underlying investments have enough liquidity. It would do you no good to purchase an ETF that meets all of the above criteria only to have thin liquidity within the underlying securities.
ETF vs. Mutual Funds Pros and Cons – Wrap Up
In the ETF vs. mutual fund match up there’s not a clear winner. If your 401(k) only offers mutual funds, then your choice is made for you. If you want the lowest fees and the opportunity to trade throughout the day, then ETFs are your answer.
If you’re concerned regarding ETF vs. Mutual Fund Performance, you can put that fear to bed. Comparable ETFs and mutual funds have similar returns and the difference between a hundredth of a percent return is insignificant over the long term.
What is most important when deciding whether or not to invest in mutual funds vs. ETFs is to start investing sooner rather than later. The more time you have invested in the markets, the more likely you are to achieve your long-term financial goals.