In the previous lesson, we covered how Exchange Traded Funds (ETFs) work via a “dancing group” metaphor. Now lets get down to business and see how ETFs are different from the slightly more famous, Mutual Funds. As the names suggest, an ETF is a fund traded on an exchange, and a Mutual Fund is a fund traded mutually. What the heck does this mean and how does it make a difference for you as an investor?
1- Young vs. Old
Mutual Funds have been around for several decades while ETFs have only been gaining popularity recently. ETFs have been around since the early 1980s, but they’ve come into their own within the past 10 years with increasing number of market participants and brokers who offer the trading services. While there is nothing wrong with an old type of investing instrument, the young kid around the block can often offer more exciting and modern opportunities as you can see in the following points.
2- ETFs are more tax efficient than Mutual Funds
The simple reason behind this is that ETFs offer tax advantages to investors because they are passively managed portfolios. Therefore they tend to decrease or avoid capital gains comparing to the actively managed mutual funds. ETF’s are traded on an exchange just like a stock, but mutual-funds shares are redeemed with the Fund directly.
If there’s one thing you give up with a mutual fund portfolio its control, especially control over when you take gains or losses. For example, in a year where a fund loses money investors may still receive legal tax application saying they owed tax, because the fund manager may have decided to sell some of the winners (in a losing year) to stop losing money from the fund in general. If you are investing with a more well-known and traditional fund like S&P 500, and you want to redeem say $30,000 from the fund, they must sell $30,000 worth of stocks to balance that out. If appreciated stocks are sold to free up the cash for the investor, then the fund captures that capital gain, which is distributed to shareholders before year-end. As a result, shareholders pay the taxes for the turnover within the fund.
Now looking at the ETFs case, when one investor sells the ETF and another buys on the exchange, the underlying securities within the ETF are not sold to raise cash for the redemption, therefore no gain- no tax. If an ETF shareholder wishes to redeem $30,000, 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.
3- ETFs have lower trading expenses comparing to Mutual Funds
Trading ETFs often has lower expenses than a similar mutual fund for 3 main reasons:
1) The passive nature of indexed strategies
2) No broker loads
3) Lower operating expenses.
While the average U.S. equity mutual fund charges 1.42 percent in annual expenses, the average equity ETF charges just 0.53 percent. If you look at where the bulk of ETF money is actually invested, the average fee is an even-lower 0.40 percent. The low cost of ETFs is mainly driven by the limited product acquisition costs, if any. ETF purchases are free of broker loads. Mutual funds can often be purchased stripped of any broker loads, but many have commissions and loads associated with them, some of which run as high as 8.5%.
4- ETFs are more flexible/ simple than Mutual Funds
When you buy or sell an ETF, it is done at one price with one transaction. You are a trade away from opening or closing a position. With mutual funds, shares in the asset are constantly being traded to hit a target price and seek a desired performance. Multiple trades, multiple prices.
An ETF is created or redeemed in large lots by institutional investors and the shares trade throughout the day between investors like a stock. Also like a stock, ETFs can be sold short. Those provisions are important to traders and speculators, but of little interest to long-term investors. When it comes to Mutual Funds, purchases and sales take place directly between investors and the fund.
The price of the fund is not determined until end of business day, when net asset value (NAV) is determined. But, because ETFs are priced continuously by the market, there is the potential for trading to take place at a price other than the true NAV, which may introduce the opportunity for arbitrage.
5- ETFs need more discipline than Mutual Funds
Let’s say you want to invest $200 every month in order to gradually grow your wealth over 5 years and buy a house. Also, let’s say that you don’t mind high transaction fees or higher taxes. All you want is an automated investment conducted without your monetarization. A Mutual Fund allows you to set an automated purchase program from her bank account. This automated purchase program is not available on an ETF. With an ETF, you would have to manually place buy orders for each trade.
6- ETFs are more accessible to an average Invest Diva/ Divo than Mutual Funds
Just like forex, you can start trading ETFs with a minimal investment unlike mutual funds. For example, you’ll have to have a minimum of $3,000 to start investing with a Vanguard 500 Index fund. But smaller investors who don’t have that capital can buy as many or few shares of Vanguard S&P 500 ETF as they want.
This is advantageous if you want to invest in many specific kinds of ETFs to have a more diversified portfolio. Without minimum requirements to invest, you can buy more ETFs that give you exposure to different markets, commodities or industries, and basically joining so many different and exciting dancing groups for a lower price.
7- ETFs don’t trade only at the end of the day like Mutual Funds
You can trade ETFs anytime throughout the day while Mutual Funds can only be traded once a day, after the markets close. The price of the ETF is determined by investor demand at any given time during the trading day which could limit the opportunities and could require more time management on the trader’s end.
These were some comparisons to make you feel good about ETFs and thirsty to wanna start trading. In the next lesson I’ll point out more details on the differences between MTs and ETFs.
(P.S. Just a thought here, no one calls Mutual Funds in its abbreviated form, “MFs” What’s up with that, Mother F@#$?! )