What makes an Exchange Traded Fund (ETF) different from a mutual fund?
Note to readers: Both of these vehicles are a "fund." Throughout this article, the term "fund" will occasionally be used when referring to both mutual funds and ETFs. We will attempt to be very clear when doing so.
Similarities Between ETFs and Mutual Funds
The best way to answer this question is to start with the similarities.
Exchange traded funds borrow their structure from the mutual fund model. Both base their value on a diverse collection of assets rather than a single investment. This is in contrast to most other financial vehicles which are linked to single properties or assets. Rather than rise or fall with direct performance, then, funds rise and fall based on net value averages.
The main purpose for both mutual funds and ETFs is stability. By linking the investment to a group of assets rather than a single property, a fund can smooth out any major price swings. If a single asset collapses it won't take out the entire fund, because the portfolio's diversity will (ideally) balance out these losses.
The other side of this moderation is that a fund also has little chance of surging. A single investment's phenomenal success will not magnify the entire investment, because the rest of the fund will balance out these gains.
Both are managed by third party companies rather than the shareholders. The purpose of a fund is to generally outperform the market while not exposing the investor to the speculative, potentially quite large, losses of an individual stock or commodity. Together mutual funds and ETFs have become extremely popular options for the retail investor, although mutual funds remain about five times as popular dollar-for-dollar.
Differences Between ETFs and Mutual Funds
If both ETFs and mutual funds offer a diverse, portfolio-based investment, how do you choose between them? There are a couple of key differences.
Purchasing and Liquidity
Perhaps the most essential difference between ETFs and mutual funds is how an investor buys them.
Shares of an ETF are traded like common stock, during normal business hours on a stock exchange. Anyone can buy or sell them, and the price of an ETF share reflects both the fund's underlying assets and its market value.
Shares of a mutual fund must be bought and sold through the fund itself or one of its authorized brokers. Often brokers will charge fees to buy into the fund or sell your shares out, and there may be rules regarding how and when you can trade your shares.
Mutual funds are valued based on Net Asset Value, or NAV. This is calculated at the close of trading every day and is based on the collected (or net) value of the assets in the fund. (A few other factors can also influence NAV, such as fund debts and share trading, but it is primarily based on the mutual fund's underlying assets.)
All of the buy and sell orders in a mutual fund are executed at the end of the day using that day's NAV after it is calculated. Typically the NAV is calculated at 4 p.m., when stock trading closes in New York City.
An ETF also calculates NAV but its share price is based on active trading. Since shares of an ETF are traded as common stock, their price is set by the market. This price will fluctuate with demand and can change during the course of the trading day. Buy and sell orders are processed in real time.
For an ETF, net asset value acts as an incentive for correction. If the market value of an ETF moves too far from the value of its underlying assets investors can use the creation/redemption method to arbitrage this back to a price that better reflects asset value.
Mutual funds have two structures. The first is called an open-ended fund. These are the traditional structure of mutual funds. They offer shares for public purchase through the fund and can issue new shares as the fund management deems appropriate.
The second mutual fund structure is called a closed-end fund. These funds issue a set number of shares and will never introduce new or remove existing shares. Share price and purchase conditions can vary based on fund manager discretion.
Exchange traded funds have three possible structures. For a retail investor, the chief difference is in how dividends are paid.
The Exchange Traded Open-Ended Index Mutual Fund may reinvest dividends into the fund on a daily basis, and pays all accumulated dividends to shareholders each quarter.
The Exchange Traded Grantor Trust pays dividends as they are accrued rather than reinvesting them. Unlike all other ETFs, investors own the underlying assets in proportion to their shares of the fund, with all the rights and responsibilities this entails.
Finally, the Exchange Traded Unit Investment Trust is an ETF with diversification requirements, including a limit that no more than 25% of the fund can be dedicated to a single asset. Dividends are not reinvested, but they are paid each quarter.
An ETF offers more advanced trading options. Unlike a mutual fund, investors can sell short the shares of an ETF. They can also place trading orders such as buy and stop loss, which is not possible given the valuation and purchase structure of a mutual fund.
Fees, Expenses and Taxes
Both vehicles use what is called an "expense ratio." This is the set of fees and costs that a fund's managers charge the investors for all costs associated with managing it. It is set as a ratio of the fund's NAV and is deducted directly from the fund's assets annually.
So, for example, a 1.0% expense ratio means that the fund managers directly deduct 1% of the fund's assets each year to cover costs, expenses, profit and all other line items in the expense ratio. (This comes out of the investor's pocket as it reduces the value of the fund which the investor partially owns.)
Mutual funds may also charge what's called a load, which is in a sense a commission by another name. Many, if not most, funds charge a load. This is priced as a percentage of either your purchase (a front-end load) or of your sale when redeeming the fund shares (a back-end load).
ETFs do not come with a load, but do come with the same broker commissions that are attached to buying and selling stocks. Some few ETFs are commission free but typically have higher expense ratios as a result.
Total costs are a fund-by-fund issue. Mutual funds with higher trade loads will typically have lower expense ratios and vice versa. An ETF typically has a significantly lower expense ratio than a comparable mutual fund, which is generally considered one of the best reasons to invest in exchange traded funds. However high-volume traders can easily pay a significant amount in trade commissions.
Finally, ETFs tend to be tax advantaged relative to mutual funds. This is because a mutual fund has higher asset turnover that affects all investors compared to an ETF. While a thorough discussion of comparative tax structures is beyond the scope of this article, the essence is that a mutual fund sells its assets more often, thus creating more taxable events, than a similarly situated ETF. This creates more tax liability for all investors in the fund. For a greater discussion of this issue, see this article by Fidelity Investments.
Which Should You Choose?
Choose an ETF for:
- More long term stability, as these are more often built around an index and passively managed.
- Lower fees and taxes.
- High liquidity and ease of trading.
- Sophisticated or active trading such as short sales and trade orders.
- Industry-focused investing, as ETFs typically have a narrower focus than mutual funds.
Choose a mutual fund for:
- Higher potential returns, as mutual funds are more often actively managed while ETFs are more often indexed, leading to potentially higher returns.
- Shorter term trading, as the active management of a mutual fund can realize gains in a shorter term than an indexed ETF.
- High volume fund trading, as a no-load mutual fund may be a better option than broker commissions on an ETF.
One final note of caution: Some ETFs can become what is called "thinly traded." This means that the fund has few or infrequent trades. This is a problem for the ETF structure, as it depends on the creation/redemption mechanism to keep the share price stable relative to the NAV. Retail investors should do their best to avoid thinly traded ETFs.