Mutual Funds or ETFs: Which one is better?
Mutual Funds vs ETFs: There are many similarities between mutual funds and exchange-traded funds (ETFs). Both types of funds offer investors the opportunity to diversify their investment portfolio through a mix of many assets. The management of these funds is, however, very different. A mutual fund can only be purchased at the end of every trading day based upon its calculated price, while exchange-traded funds can be traded like stocks. Actively managed mutual funds also make decisions regarding how assets within the fund are allocated. However, ETFs are usually passively managed and based on a specific market index, instead of actively managed.
In Dec. 2018, there were 805 mutual funds with a total of $17.71 trillion in assets, according to the Investment Company Institute. ICI’s research on ETFs, conducted for the same period, reported 1,988 ETFs with combined assets of $3.37 trillion.
Mutual Funds
In exchange-traded funds, investments need to be higher than those in mutual funds. Funds and companies have different requirements. Vanguard 500 Index Investor Funds require a minimum investment of $3,000, for example. There is a $250 initial deposit required for the Growth Fund of America offered by American Funds.
Investing in stocks or other securities within a mutual fund can be actively managed by a fund manager or team in order to beat the market and help their investors profit. Due to the time, effort, and manpower that these funds require, they are usually more expensive.
Investors and mutual funds directly transact on purchases and sales of mutual funds. When the fund’s net asset value (NAV) is determined at the end of the day, its price is determined.
Two Kinds of Mutual Funds
Mutual funds can be categorized in two ways under the law:
Open-Ended Funds
The mutual fund industry is dominated by these funds in terms of assets under management and volume. Fund shares are purchased and sold directly between investors and the fund company with open-ended funds. An open-ended fund is permitted to issue any number of shares. The fund is able to issue more shares as more investors buy shares.
In order to comply with federal regulations, each day the value of a fund’s portfolio (assets) needs to be appraised, a process known as marking to market. There is no connection between the number of outstanding shares and the value of an individual’s shares.
Closed-End Funds
Funds that issue a fixed number of shares do not produce new shares as investor demand rises. The net asset value of a fund has little effect on the price of the fund, which is driven by investor demand. A share may be purchased at a discount or a premium to its NAV.
Exchange-Traded Funds (ETFs)
A single share of an ETF, plus fees and commissions, can cost as low as one cent for an entry position. ETF shares trade between investors throughout the day as if they were stocks. Institutional investors create and redeem ETFs in large lots. Short sales of ETFs are possible as well.
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Long-term investors may not be concerned with those provisions, but traders and speculators are. However, because ETFs are continuously priced in the market, trading may happen at a different price from the true NAV, thus allowing for arbitrage opportunities.
Investors can benefit from tax advantages with ETFs. Actively managed mutual funds significantly outperform ETFs (and index funds) as passively managed portfolios.
Due to the way they are created and redeemed, ETFs are more tax-efficient than mutual funds.
Mutual Fund vs. ETF Example
As an example, let’s say that an investor withdraws $50,000 from a traditional Standard & Poor’s 500 Index fund (S&P 500). The fund has to sell $50,000 in stock to compensate the investor. The fund captures the capital gain when appreciated stocks are sold to free up money for the investor and distributes it to shareholders before the end of the year.
Consequently, the fund’s shareholders pay the taxes associated with its turnover. Shareholders of an ETF who request redemption of $50,000 will not have to sell any stocks. Investors have the option instead of paying capital gains by redeeming their shares in kind.
Three Kinds of ETFs
There are three legal classifications for ETFs:
Exchange-Traded Open-End Index Mutual Fund.
The fund has been registered for the first time under the Investment Company Act of 1940, meaning dividends are repaid to shareholders every quarter and reinvested on the day of receipt.3 Securities lending is allowed, and derivatives may also be used in the fund.
Exchange-Traded Unit Investment Trust (UIT)
The Investment Company Act of 1940 also applies to exchange-traded UITs, but these are required to fully replicate their specific indexes, set a limit on investments in a single issue of 25% or less, and include weighting ratios for diversified and non-diversified funds.
It pays cash dividends quarterly rather than automatically reinvesting dividends. The Dow DIAMONDS, a type of QQQQ, exhibits this structure.
Exchange-Traded Grantor Trust
Like closed-ended funds, ETFs of the type described here are owned by investors, but their underlying shares are owned by the companies in which they invest. Investors are entitled to vote on them.
Despite this, the fund’s composition remains the same. We do not reinvest dividends but forward them directly to shareholders. Each investor must trade one hundred shares at a time. A typical ETF of this type is the holding company depository receipt (HOLDR)