Mutual Fund vs. ETF: An Overview
When comparing mutual funds to exchange-traded funds, it is important to take into account their fundamental discrepancies. While ETFs allow for intraday trading akin to stocks, mutual funds are only accessible for purchase at the conclusion of each trading day, pegged to a calculated value referred to as the net asset value.
Mutual funds, in their current form, have been in existence for nearly a century, with the inaugural mutual fund launched in 1924. In contrast, exchange-traded funds are recent additions to the investment landscape, with the inception of the first ETF in January 1993: the SPDR S&P 500 ETF Trust (SPY).
The majority of mutual funds are actively managed, signifying that fund managers oversee the allocation of assets within the fund. Conversely, ETFs are generally passively managed, tracking market indexes or specific sector indexes. However, this distinction has become less clear as passive index funds constitute a significant portion of mutual funds’ assets under management, while an increasing array of actively managed ETFs is now available to investors.
Key Takeaways
- Mutual funds are typically actively managed, although passively-managed index funds have gained popularity.
- ETFs are usually passively managed and track a market index or sector sub-index.
- ETFs can be traded like stocks, unlike mutual funds which can only be bought at the end of each trading day.
- Actively managed funds often entail higher fees and higher expense ratios due to increased operational and trading costs.
- An open-ended mutual fund has no limit to the number of shares, whereas a closed-ended fund has a fixed number of shares regardless of investor demand.
Mutual Funds
On average, mutual funds typically impose a higher minimum investment requirement than ETFs. While there are funds with no minimum investment, a standard retail fund necessitates a minimum investment ranging between $500 and $5,000.
These minimums can fluctuate contingent on the fund type and company. For instance, the Vanguard 500 Index Investor Fund Admiral Shares necessitates a $3,000 minimum investment, while The Growth Fund of America, offered by American Funds, demands a $250 initial deposit.
Numerous mutual funds are actively managed by a fund manager or team who make decisions regarding the purchase and sale of stocks or other securities within the fund to outperform the market and yield profits for their investors. These funds generally incur higher costs owing to the substantial time, effort, and workforce required for securities research and analysis.
The purchase and sale of mutual fund units transpire directly between investors and the fund, with the fund’s price not determined until the conclusion of the business day when the net asset value (NAV) is computed.
Types of Mutual Funds
Mutual funds are legally categorized into two classes: open-ended and closed-end. The distinctions between these classifications lie in the issuance of fund shares.
Open-Ended Funds
Open-ended funds dominate the mutual fund marketplace in terms of volume and assets under management. These funds facilitate the purchase and sale of fund shares directly between investors and the fund company, with no limits on the number of shares the fund can issue. Consequently, as more investors invest in the fund, additional shares are issued. Federal regulations mandate a daily valuation process, known as marking to market, which subsequently adjusts the fund’s per-share price to reflect fluctuations in portfolio (asset) value.The worth of an individual’s stocks is unaffected by the total number of shares that are available for trading.
Closed-End Funds
These funds release only a fixed amount of shares and do not generate new shares as investor demand increases. Prices are not determined by the net asset value (NAV) of the fund but are driven by investor demand. Purchases of shares are frequently made at a premium or discount to NAV.
Prior to making decisions on how and if these two investment options fit into your portfolio, it is crucial to consider their distinct fee structures and tax implications.
Exchange-Traded Funds (ETFs)
ETFs have the potential for far lower entry costs – as minimal as the price of a single share, plus fees or commissions. An ETF is fashioned or redeemed in large quantities by institutional investors and the shares are traded throughout the day among investors similar to a stock. Just like a stock, ETFs can be sold short. These provisions are crucial to traders and speculators, but of minor relevance to long-term investors. However, as ETFs are priced continuously by the market, the potential for trading at a price different from the true NAV exists, which could create the opportunity for arbitrage.
ETFs present tax advantages for investors. As passively managed portfolios, ETFs (and index funds) have a tendency to realize fewer capital gains than actively managed mutual funds.
By the Numbers…
The United States holds the foremost position as the largest market for mutual funds and ETFs, representing 48% of total global assets of $60.1 trillion in regulated open-end funds as of the beginning of 2023. According to the Investment Company Institute, in 2022, U.S.-registered mutual funds had $22.1 trillion in assets, compared with $6.5 trillion in assets for U.S. ETFs. At the end of 2022, there were 8,763 mutual funds and 2,989 ETFs in the U.S.
ETF Creation and Redemption
The creation/redemption process sets ETFs apart from other investment instruments and offers several advantages. Creation involves purchasing all the underlying securities that form the ETF and bundling them into the ETF structure. Redemption entails “unbundling” the ETF back into its individual securities.
The ETF creation and redemption process takes place in the primary market between the ETF sponsor – the ETF issuer and fund manager who administers and markets the ETF – and authorized participants (APs), who are US-registered broker-dealers with the right to create and redeem shares of an ETF. The APs assemble the securities included in the ETF in their appropriate proportions and deliver those securities to the ETF sponsor.
For instance, an S&P 500 ETF would require the APs to create ETF shares by assembling all the S&P 500 constituent stocks – based on their weights in the S&P 500 index – and delivering them to the ETF sponsor. The ETF sponsor then bundles these securities into the ETF wrapper and delivers the ETF shares to the APs. ETF share creation generally occurs in large increments, such as 50,000 shares. The new ETF shares are then listed on the secondary market and traded on an exchange, similar to stocks.
With an ETF redemption, the process is the converse of ETF creation. APs aggregate ETF shares, referred to as redemption units in the secondary market, and deliver them to the ETF sponsor in exchange for the underlying securities of the ETF.
ETF Benefits
The unique ETF creation/redemption process results in ETF prices closely mirroring their net asset value, due to the APs closely monitoring the demand for an ETF and promptly taking action to mitigate significant premiums or discounts to the ETF’s NAV.
The creation/redemption process also means that the ETF’s fund manager does not need to buy or sell the ETF’s underlying securities except when the ETF portfolio has to be rebalanced. Since an ETF redemption is an “in kind” transaction involving ETF shares being exchanged for the underlying securities, it is typically tax-exempt.Consequently, the process of generating and redeeming shares of a mutual fund might activate tax responsibilities for all investors involved, something less likely for ETF shareholders who are not engaged in share trading. It is crucial to note that capital gains tax remains applicable when ETF shares are sold, although investors have the option to decide when to do so.
ETFs might be more tax efficient than mutual funds owing to their creation and redemption mechanisms. It is essential to comprehend their differences accurately. Both ETFs and mutual funds are overseen by fund administrators who strive to accomplish the fund’s specified investment aims. For instance, an S&P 500 mutual fund or ETF typically seeks to replicate the composition and returns of the S&P 500 index, enabling investors to purchase shares in the fund to gain access to its complete array of securities.
One of the fundamental differences between ETFs and mutual funds lies in their trading methods. Unlike mutual funds, where shares are bought and sold directly with the fund provider, ETF shares can be traded among investors. Additionally, transactions for mutual funds only occur after trading ceases for the day, allowing the fund manager to ascertain the share value in the fund.
In contrast, Exchange-Traded Funds (ETFs) have a trading pattern similar to that of stocks. Acquiring and disposing of ETF shares on the open market with fellow investors is feasible. Although it is less common, purchasing or exchanging shares with the fund provider is also an option. Due to the fact that these shares are traded throughout the day, rather than after market closure, ETFs prove to be more favourable for active traders.
ETFs are often more affordable to invest in. Traditional mutual funds often necessitate minimum investment amounts of hundreds or thousands of dollars, while the purchase of a single share is sufficient for ETF investment. Furthermore, as ETFs are typically managed passively, and some mutual funds employ a more active approach, ETF expense ratios are generally lower.
A Practical Comparison of Mutual Fund and ETF Redemptions
For instance, assume an investor redeems $50,000 from a traditional Standard & Poor’s 500 Index (S&P 500) fund. In order to fulfil the investor’s request, the fund is required to sell $50,000 worth of stocks. If the sold stocks have appreciated, the fund captures the capital gain, which is then distributed to shareholders prior to year-end.
Consequently, shareholders are accountable for the tax implications of the fund’s internal trading. Conversely, should an ETF shareholder seek to redeem $50,000, the ETF does not engage in selling any stock within its portfolio. Instead, it offers shareholders “in-kind redemptions,” thereby limiting potential capital gain taxes.
Which is the More Suitable Investment Vehicle: Mutual Fund or ETF?
The primary distinguishing factor between a mutual fund and an ETF lies in the intraday liquidity the latter offers. Hence, if the ability to trade similar to a stock holds significance for an individual, an ETF may be the more advantageous choice.
Are ETFs More Volatile Than Mutual Funds?
Although ETFs and mutual funds which mirror similar strategies or track identical indices are structured somewhat differently, there is no compelling reason to believe that one is inherently riskier than the other. The level of risk associated with a fund is mainly contingent upon the underlying holdings and not on the investment’s structure.
Do Index ETF and Mutual Fund Fees Differ with Similar Passive Strategies?
The discrepancy in fees presently is negligible in many instances. For instance, some of the largest and most popular S&P 500 ETFs possess an expense ratio of 0.03%. Vanguard’s S&P 500 ETF (VOO) features an expense ratio of 0.03%, while the Vanguard 500 Index Fund Admiral Shares (VFIAX) exhibits an expense ratio of 0.04%.
Do ETFs Distribute Dividends?
Indeed, numerous ETFs provide dividend distributions based on the dividend payments of the stocks held within the fund.
Have Index Funds Gained Popularity?
Index funds, which mirror a market index’s performance, can be established in the form of either mutual funds or ETFs. These funds have garnered more attention than actively managed funds due to their reduced research and management costs, ultimately translating to lower expense ratios for the investor. According to research conducted by the UCLA School of Management, the combined net assets in both categories of index funds have surged from 25% to approximately 50% of all investment funds between 2013 and 2023.
In Conclusion
Mutual funds and exchange-traded funds represent two prominent avenues for diversified portfolio investments, as opposed to relying solely on individual company success. The key distinction lies in the fact that ETFs, akin to regular stocks, can be traded throughout the day. Conversely, mutual funds can only be traded once per day, following the close of the market.