The nearly century-old mutual fund and its more modern relative, the exchange traded fund (ETF) are both investment vehicles made up of a diversified portfolio of securities. You can buy shares of these funds through brokerages or other providers, thereby having a financial stake in many companies at once.
Differences in how each type of fund is structured, traded, and taxed can make one or the other a better fit, depending on your investing preferences and style. The best way to determine which type of fund suits you is to learn about them and how they work.
Mutual funds vs. exchange traded funds (ETFs)
Structurally, mutual funds and ETFs are similar. Both hold assets in the form of securities (i.e., stocks or bonds) and both sell shares of those assets to investors. The rules that determine how investors interact with each type of fund are one of the ways the funds differ.
Mutual funds: A pool of invested funds actively managed by a fund manager whose goal is to create income by meeting or beating an established benchmark.
ETFs: A pool of invested funds passively managed by a fund manager whose goal is to create income by tracking a particular index of stocks.
“ETFs originally took a more passive approach, meaning they just tracked the investments in an index like the S&P 500. Now, similar to mutual funds, there are active and passive ETFs. The majority of ETFs are still passive, with some of the active options being smaller in terms of funds under management,” says Michael Doniger, COO of UNext.
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A deeper dive shows how these funds are structured, how they function, and what their strengths and weaknesses are.
What are mutual funds?
Mutual funds are investments that pool money from many investors and use it to acquire equities or stocks which become the fund’s portfolio. The fund is operated by professional managers who actively attempt to increase the fund’s value by buying and selling assets based on the objectives of the fund.
The mutual fund’s total value depends on the value of all the stock in which it invests and how well that stock performs in the market. The value of a single mutual fund share, also known as net asset value (NAV), is determined by dividing the total value of the fund’s assets, minus liabilities by the total number of outstanding shares.
Investors who lack the interest, experience, or funds to buy individual stocks, may see an actively managed mutual fund as a desirable addition to their portfolio. The desire for diversification, professional management, and low risk without a lot of effort makes this type of investment a good fit for many people.
How mutual funds work
When you invest in a mutual fund you receive fund shares (not actual stock) based on the amount you invest (I) divided by the current NAV of a single share.
I/NAV = # of shares
For example, if you invest $1,000 in a mutual fund whose current NAV is $30, you will receive 33.33 shares.
$1,000/$30 = 33.33
If the NAV goes up $1 by the end of the next trading day, you will have realized a gain of $33.33 and your original $1,000 investment is now worth $1,033.33.
33.33 x $1 = $33.33 + $1,000 = $1,033.33
This process can continue with the value of your investment rising (or falling), depending on the performance of the stocks in the fund.
If you decide to sell some (or all) of your shares, you will do so at the end of the market day, based on the NAV at that time.Your profit will depend on any increase in the NAV of your shares minus expenses such as sales loads, and capital gains taxes times the number of shares you sell. You can earn money with mutual funds three ways, dividends, capital gains distributions, and the aforementioned rise in the NAV.
Pros and cons of mutual funds
Although ETFs have replaced mutual funds in many portfolios, the advantages of mutual funds outweigh the disadvantages in the minds of certain types of investors, including those for whom professional management and convenience trump higher fees.
Pros of mutual funds
Diversification. For those who want instant diversification and lack the interest, time, or funds to build from scratch with individual stocks, mutual funds provide an easy gateway to that goal.
Professional management. Actively managed mutual funds provide opportunities for better earnings than with index funds due to the expertise of the managers.
Fractional shares. One of the most tried and true investing strategies is “dollar-cost investing” in which a specific amount is invested on a schedule. Mutual funds allow fractional shares, ensuring the full amount of your investment will go to work on your behalf.
Convenience. Mutual funds let you automatically reinvest dividends and capital gains distributions.
Cons of mutual funds
Higher expense costs. Professional expertise comes at a cost, and so actively managed mutual funds typically have higher investment costs than passively managed ETF funds.
Higher capital gains taxes. Since mutual funds pass along capital gains at the end of the year, shareholders have to pay taxes on those gains, even if the fund performed poorly on the whole.
Lack of transparency. Unlike ETFs which must disclose their holdings daily, mutual funds do not have that requirement making the funds less transparent.
Less liquidity than ETFs. Mutual fund shares can only be redeemed once per day after trading is over, making them less liquid than stocks or shares of ETFs.
History of underperformance. A recent study by researcher Tong Yao, professor of finance at the University of Iowa Tippie College of Business, found that even passively managed mutual funds underperform their ETF counterparts by 42 basis points in annualized returns. “The bulk of that underperformance is the result of investor service costs and the need to maintain cash on hand to pay for redemptions, also known as cash drag,” says Tong.
What are ETFs?
ETFs are a type of exchange-traded investment product that must register with the Securities and Exchange Commission (SEC). ETFs offer a pooled investment in a fund that buys stocks and grants investors shares similar to a mutual fund. Most ETFs are passively managed meaning the fund tracks a specific index such as the S&P 500, which negates the need for expensive active management.
Since ETF shares are traded on a stock exchange during the trading day, each share’s value changes constantly and may or may not equal the NAV of the fund’s shares. An ETF’s NAV is calculated the same as with a mutual fund, by taking the value of the ETF’s assets minus its liabilities divided by the number of shares outstanding.
As with mutual funds, ETFs appeal to investors for a variety of reasons. Portfolio diversification is a major feature with liquidity a close second due to the ability to buy and sell shares on the exchange. Transparency and tax efficiency complete the list of reasons ETFs are part of many investment plans today.
How ETFs work
Investing in an ETF is similar to investing in the stock market since fund shares are traded (i.e., bought and sold) on a stock exchange at a market price that changes throughout the day. As with a mutual fund, you are not buying the actual stock but rather shares of the fund that is invested in the stock.
“Because of their constant trading during market hours, ETFs can be thought of as being more tactical from a trading perspective,” notes Robert Reilly, member of the finance faculty at Providence College School of Business. “Long-term investors may be less interested in the trading aspects of this product.”
When buying ETF shares, you do not normally invest a specific dollar amount, but rather purchase a certain number of shares at the current market price. That’s because, unlike mutual funds, ETFs do not usually offer fractional shares.
Suppose, for example, you have the same $1,000 to invest in ETFs and the market price of the shares you wish to purchase is $30. Since you normally can’t purchase a fractional ETF share, you would receive 33 shares for $990 ($1,000/$30 = 33.33) and have $10 left as cash until you are able to add $20 to it to buy another share.
If the market price rises by $1, you could sell your shares and realize a profit of $33 (not $33.33 as with the mutual funds). Keep in mind that you buy and sell shares based on the market price, not the NAV. Although the market price and NAV are typically not much different from each other, variances do happen. When the market price is higher than the NAV, the shares are said to be selling at a premium. When the market price is lower than the NAV, the shares are said to be selling at a discount.
Some traders take advantage of the variance between market price and NAV, but it is very difficult to do. Most investors trade based on variance in market price or buy-and-hold to realize profit over the long haul through dividends and capital gains.
Pros and cons of ETFs
Similar to mutual funds, ETFs have advantages and disadvantages, though arguably fewer disadvantages than mutual funds, depending on your investing approach.
Pros of ETFs
Diversification. As with mutual funds, ETFs provide an easy, cost-efficient way to increase your portfolio holdings without the need to buy individual stocks.
Tax efficiency. “ETFs are more tax efficient on the fund-holdings level due to their exchange-traded nature,” says Jeremy Schwartz, Global Chief Investment Officer at WisdomTree. “Further, shares of the ETF can be passed back and forth on the exchange, thereby reducing the chance for capital gains.”
Tradeability. Since ETFs trade like stock you have the opportunity to take advantage of share price fluctuations throughout the trading day.
Transparency. “Holdings in an ETF in almost all circumstances are required to be disclosed on a daily basis so investors know what they own,” advises Stephen Gardner, director at ETFMG. “Mutual funds typically only disclose their holdings quarterly with a 30-day lag.”
Liquidity. “Since an ETF can be bought or sold throughout the entire trading day on an exchange, that adds a further layer of liquidity,” notes Schwartz.
Cons of ETFs
Lack of fractional shares. Compared to mutual funds where investments are dollar-based, most ETFs do not offer fractional shares, meaning you must invest in whole shares no matter how much they cost.
Passive management. For ETFs that follow an index, there is no attempt to beat the benchmark, thereby potentially seeing smaller gains.
Tracking error. “ETFs do on the downside have some tracking error,” says Derek Horstmeyer, Professor of Finance at George Mason University School of Business. “In other words, they might not reflect their holdings exactly.”
How to choose between the two
When considering the differences between mutual funds and ETFs, one conclusion is unavoidable: Most actively managed mutual funds fail to achieve their objective of beating a benchmark.
“It’s important to know that less than 25% of active mutual fund managers outperform their benchmarks over long time periods,” says Mengfei (Grace) Gu, Research Analyst at investment advisory firm, Arnerich Massena. “Thus, the selection of active managers is very important to the outcome of the portfolio.”
This does not mean mutual funds, especially actively managed funds are never appropriate. First, some active managers do meet or beat the benchmark on a consistent basis. If you find one, are seeking higher returns on your investments, and are willing to take the risks, an actively managed fund might be for you. For most people, however, experts tend to prefer the newer exchange traded funds with lower costs and more tax efficiency over actively managed mutual funds.
If you are still uncertain, you may want to consider the advice of Nancy J. Hite, CEO of The Strategic Wealth Advisor who says simply: “Get professional help, don’t try to be your own medical doctor with investments.”
This story was originally featured on Fortune.com
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