Summary;TL/DR
Mutual funds and ETFs are both investment vehicles that are widely used in the world of investing. Their differences, while nuanced, are still worth paying attention to. The pricing mechanisms for both vehicles are different, as well as how they are traded, taxed, and invested. At the end of the day, I feel that ETFs have the upper hand when compared to mutual funds, although the latter can still play a role in one’s portfolio under the right circumstances.
Introduction
Mutual funds and ETFs (Exchange Traded Funds) are often thought of as interchangeable in the world of finance. And while there are certainly plenty of similarities between the two, there are plenty of differences as well. In this post, I’ll discuss what these two investment vehicles have in common, what their differences are, and the advantages and disadvantages of each.
Common Ground
I fear that jumping straight into the differences between mutual funds and ETFs will sew more confusion than clarity. Beginning with their common characteristics, on the other hand, should make it easier to understand their differences.
The primary, and hopefully most obvious, similarity is that both mutual funds and ETFs are funds. That is, their managers are tasked with an investment objective (growth, income, reduced volatility, etc) and invest a pool of funds in pursuit of it. The fund issues fractions of ownership in their investment pool, called shares.
Funds, whether they be mutual funds or ETFs, are exceptionally good at providing diversification and simplification to one’s investment portfolio. Instead of needing to purchase dozens of stocks on your own, you can instead purchase a single fund that owns dozens of stocks. In fact, it’s not rare for a fund to own hundreds of companies.
At a high level, therefore, mutual funds and ETFs have a lot in common. Their differences, as we’ll see below, are relatively nuanced and have to do with how they are priced, where they are traded, and how they are taxed.
Net Asset Value vs Market Price
The price of an ETF fluctuates with supply and demand, just like any other stock that trades on an exchange (such as the New York Stock Exchange). They are traded at all hours that the market is open.
The price of a mutual fund, on the other hand, is determined by its Net Asset Value (NAV), which is essentially the net worth of the fund, or the value of the underlying portfolio. Since the NAV of the fund is in a constant state of change while the market is open, any buy or sell orders placed for a mutual fund are honored after the NAV is calculated at the end of the trading day.
A more technical difference is that mutual funds are bought/sold on the primary market, while ETFs are bought/sold on the secondary market. When you purchase a fund from the primary market, you buy/sell it directly to the issuer of the fund. Funds traded on the secondary market, however, are traded between individual investors.
Think of it this way – “ETFs are like mutual funds that trade like stocks”. While there is certainly more to the story than this, this is a reasonably fair summary of the differences that we’ve discussed so far.
Passive vs Active
Passive investment is commonly referred to as “buy and hold”. The idea is that you purchase a well-diversified basket of stocks and don’t make any changes except for annual or semi-annual rebalancing. Active management, on the other hand, employs a variety of strategies that aim to provide performance superior to that which a passive investor would earn.
There has been tons of research investigating the success of active investment management vs passive, and the results are clear – passive investment management is far superior. As early as September 2023, researchers found that over 90% of all fund managers underperformed their passive benchmarks over a 20-year period. Furthermore, when you consider that a non-insignificant amount is charged by active fund managers in their quest for outperformance, you come to the sober conclusion that many investors won’t only underperform, but they will underperform and pay!
While there isn’t anything about ETFs/mutual funds that impel them to be active as opposed to passive, the fact of the matter is that most mutual funds are active in nature whereas most ETFs are passive in nature. Mutual funds, therefore, are generally far more expensive and far more likely to underperform than their passive ETF counterparts.
Finally, the fact that more ETFs are passive means that you are more likely to find an ETF that specializes in any given passive strategy, whereas there aren’t likely mutual fund options available for that specialty at all. There are passive ETFs that track small-cap Chinese tech stocks, ETFs that short the currencies of various countries, and ETFs that track the price of cryptocurrencies. And the opposite is true of mutual funds – if you’re looking for a fund that engages in a strategy that requires active management, you’re more likely to find a mutual fund that fits the bill.
Tax Advantages of ETFs
When it comes to taxes, ETFs are far superior to mutual funds. This is primarily due to higher capital gains distributions made by mutual funds because of them selling on the primary market. Think about it this way – to meet redemptions of fund shares in cash, managers of mutual funds must sell stock from within the fund to obtain the cash. Oftentimes, this results in capital gains being incurred from within the fund! At the end of the year, these capital gains get distributed to taxpayers and can be a huge surprise. It’s not uncommon to receive these capital gains distributions from mutual funds even in a year where the fund’s value went down.
ETFs, on the other hand, do not share these same issues since they are traded on the secondary market. Transactions between investors don’t affect the underlying portfolio in any way. Furthermore, when the fund does make redemptions (primarily to institutional investors), they are able to do so “in-kind” – a mechanism known as in-kind redemptions. In a nutshell, the fund redeems shares of its fund in exchange for the underlying stock, unlike a mutual fund which may only redeem shares in cash which it has to sell stock (and incur gains) to receive.
Conclusion
Considering the above, ETFs come out far ahead of mutual funds in my opinion. I rarely use mutual funds for my clients and, when I do, they serve a very specific purpose in their portfolio. The tax and cost advantages of ETFs alone help explain why they have become so popular in recent years, and why they will likely continue to gain market share over investible assets.
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