ETF’s and Mutual Funds: What’s the Difference?

etf-mutual-fund-difference

If you are looking to make your money work for you, funds can be a great option. Mutual and ETF’s are two kinds of funds to consider. These funds have a lot in common, but they also have their share of differences; mainly in the way they are managed.

I personally favor ETF’s because I like the flexibility they offer for trading. Read on to find out about these types of funds and how you can take advantage of what they have to offer to make the most of your money.

I got most of my research for this article from the following source:

Investopedia: Mutual Fund vs. ETF: What’s the Difference?

Mutual Funds vs. ETF’s

When comparing the key differences between Mutual Funds and ETF (Exchange Traded Funds) the biggest difference lies in the way they are managed. 

ETF’s can be traded like stocks while mutual funds can only be traded at the end of the day based on a calculated price. Mutual funds are also actively managed. This means a funds manager makes decisions on the best way to allocate the fund. 

ETF’s are funded in a passive manner based on a particular market index. 

Mutual funds tend to have higher fees and higher expense ratios as compared to ETF’s. This is hugely in part to the fact that they are actively managed and, therefore, incur higher costs. According to the Investment Company Institute, in Dec. of 2018, there were 8,059 mutual funds with a total of $17.71trillion in asset and a total of 1,988 ETF’s with a total of $3.37 trillion in assets. 

Mutual Funds

Now, let’s take a closer look at what mutual funds are. 

Mutual funds usually come with a higher minimum investment requirement than ETF’s. Minimums will vary according to the type of company you are investing in. Some companies require minimum investments of thousands of dollars while others only require a couple hundred. 

Many mutual funds are actively managed by a fund manager or team that makes decisions to buy and sell stocks and other securities so their customers can profit. Because there is more effort involved in managing the funds, they tend to cost more.

The purchases and sales of funds take place between the investor and the fund. The price of the fund is determined at the end of the business day in accordance with its net asset value

There are two types of mutual funds. These are as follows: 

Open Ended Funds: These are the most common type of mutual fund. There is no limit to the number of shares the fund can issue. So, as more investors buy into the fund the more shares that can be issued. 

Federal regulations require a daily valuation process called marking to market. This process adjusts the funds price per share to reflect changes in the asset value. The value of the shares is not affected by the number of shares that are outstanding.

Close End Funds: The other type of mutual funds are called close end funds. These issue a specific number of shares and do not issue more shares according to investor demand. Prices are not determined by the net asset value (NAV) of the fund but rather, they are driven by investor demand. Purchases of shares are often made at a premium or discount to NAV.

When compared to an ETF

Exchange Traded Funds (ETF’s): ETF’s can cost far less than mutual funds, especially for those investing at an entry level. They are created or redeemed in large lots by institutional investors and the shares trade throughout the day between investors like a stock. Because the operate similar to a stock, they can be sold short. 

Because ETF’s are priced by the market on an ongoing basis, there is potential for trading to take place at a price that varies from the NAV. This leaves the door open to arbitrage, the simultaneous buying and selling of securities, currency or commodities in different markets in order to take advantage of differing prices for the same asset. It also makes the funds not as attractive to long term investors. 

ETF’s can be an attractive option as they are more tax efficient than mutual funds. Because they are passively managed, they tend to realize fewer capital gains. 

Let’s take a look at how ETF’s can work as to the investor’s tax advantage.

If an investor redeems $50,000 from a traditional index fund, the fund must sell $50,000 in order for the investor to break even on his investment. If appreciated stocks are sold to free up cash for the investor, the fund captures that capital gain which is distributed to shareholders before the end of the year. 

As a result, the shareholders pay the taxes for the fund’s turnover. 

If a shareholder wants to redeem the $50,000, the ETF doesn’t sell any stock in the portfolio. Instead it offers shareholders ‘in-kind redemptions’ which limit the possibility of paying capital gains. 

There are three different kinds of ETF’s available. These are as follows:

Exchange Traded Open-End Index Mutual Fund: This type of fund is registered under the SEC’s Investment Company Act of 1940. Therefore, the dividends are reinvested on the day they are received and paid out to shareholders in cash each quarter. Security lending is permitted, and derivatives may be used in the fund. 

Exchange Traded Unit Investment Trust (UIT): These are governed by the Investment Company Act of 1940 and attempt to replicate their specific indexes and limit investments to be issued in increments of 25% or less setting additional weighting limits for diversified and non-diversified funds. They do not automatically reinvest dividends. Rather, they pay cash dividends quarterly. 

Exchange Traded Grantor Trust: This type of ETF is similar to a close ended mutual fund, but an investor owns the underlying shares in the company in which the EFT is invested. Therefore, he is a shareholder in the company and has the voting rights associated with being a shareholder. Regardless, the composition of the fund does not change. 

Dividends are not reinvested but paid directly to shareholders. Investors must trade in 100-share lots.

Final Thoughts

Mutual funds and ETF’s have their share of advantages and disadvantages when it comes to investing your money. Which do you think is right for you? For myself, I avoid mutual funds and strictly do ETF’s.

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