Mutual Fund or ETF? Whatis the right for you?

March 18, 2015 / Knowledge Centre

Both Mutual funds and exchanged traded funds (ETFs) are simple ways to invest into a group of assets. Most are focused on a specific country, industry, asset type, investment strategy, or combination of these. They can be thought of as owning a small part of an investment holding company, since the investor is acquiring ownership in the collective assets held by the fund. The main benefit of both mutual funds and ETFs is a lower costs for holding a diversified mix of assets

Mutual funds have been a popular way to invest for several decades while Exchange Traded Funds, or ETFs as they are they’re commonly known, are relatively new but are quickly gaining popularity for their low-cost and their better tax treatment. There are some differences of which you should be aware.

All mutual funds have expenses including commissions, redemption fees and operational expenses. Commissions, or “loads” as they are sometimes called, are either front-ended (ie, paid on purchase) or back-ended (ie, paid on sale). Early redemption fees are to discourage excess turnover and occur only if the fund is sold prior to a specific period of time. Operational fees include managements costs and miscellaneous fees such as advertising or distribution expenses.

Exchange traded funds (ETFs) have several similarities to mutual funds. Like a mutual fund, an ETF is a pool or basket of investments. However, ETFs usually have much lower expenses than a similar mutual fund because there are no commissions and very low operating expenses. There is typically no active management with ETFs, as they invest passively in a group of assets with predetermined conditions. Mutual funds have the benefit of investment managers who make active decisions about assets held by the fund.

Both ETFs and mutual funds are viable choices for investors. With many mutual funds and ETFs available on the market, it’s important for investors to familiarize themselves with the differences between products to ensure they are making appropriate investment decisions.

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Legal Structure of Mutual Funds

Both mutual funds and ETFs can vary in terms of their legal structure. Mutual funds can typically be broken down into two types.

  • Open-End Funds

    These funds are a collective investment scheme, which can issue and redeem shares at any time. An investor will generally purchase shares in the fund directly from the fund itself rather than from the existing shareholders.

  • Close-End Funds

    These funds are a collective investment model based on issuing a fixed number of shares which are not redeemable from the fund, but are bought and sold from existing shareholders.

Legal Structure of ETFs

An ETF will have one of three structures:

  • Exchange-Traded Open-End Index Mutual Fund

    This fund is registered under the Unite States SEC’s Investment Company Act of 1940, whereby dividends are reinvested on the day of receipt and paid to shareholders in cash every quarter. Securities lending is allowed and derivatives may be used in the fund.

  • Exchange-Traded Unit Investment Trust (UITs)

    Exchange-traded UITs are also governed by the Investment Company Act of 1940, but must attempt to fully replicate their specific indexes, limit investments in a single issue to 25% or less, and set additional weighting limits for diversified and non-diversified funds. UITs do not automatically reinvest dividends, but pay cash dividends quarterly.

  • Exchange-Traded Grantor Trust

    This type of ETF bears a strong resemblance to a closed-ended fund but, unlike ETFs and closed-end mutual funds, an investor owns the underlying shares in the companies that the ETF is invested in, including the voting rights associated with being a shareholder. The composition of the fund does not change; dividends are not reinvested but instead are paid directly to shareholders.

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Trading Process

ETFs offer greater flexibility than mutual funds when it comes to trading. Purchases and sales take place directly between investors and the fund. The price of the fund is not determined until the end of a business day, when net asset value (NAV) is determined. An ETF, by comparison, is created or redeemed in large lots by institutional investors and the shares trade throughout the day between investors like an equity.

Expenses

Due to the passive nature of indexed strategies, the internal expenses of most ETFs are considerably lower than those of many mutual funds.

Mutual funds justify their management fees by attempting to outperform a certain benchmark using active trading strategies. If a fund can outperform its benchmark by at least the management fee, then an investor can justify paying the higher fees.

Another expense that should be considered is the purchase costs, if any. Mutual funds can often be purchased at NAV, meaning there is no commission taken, but many mutual funds (they are often sold by an intermediary) have commissions and loads associated with them, some of which can be very high. ETF purchases are free of broker loads.

In both cases, additional transaction fees are usually assessed, but pricing will largely depend on the size of your account, the size of the purchase and the pricing schedule associated with each brokerage firm.

ETF Tax Efficiency

ETFs are more tax effective than mutual funds. An ETFs ability to reduce or avoid capital gain distributions comes from two differences: Unlike mutual-funds where shares are redeemed with the fund directly, ETFs are traded on an exchange just like an equity. When one party sells the ETF and another buys the ETF on the exchange, the underlying securities within the ETF are not sold to raise cash for the redemption, therefore there is no capital gains tax. The redemption process also enables the fund manager to sell the most effective cost-basis stocks through stock transfers during the redemption or creation process. These characteristics can also mean a difference in the after-tax rate of returns from a mutual fund versus an ETF, even when they both replicate the same underlying index.

Liquidity

Liquidity is usually measured by the daily trade volume, generally expressed as the number of shares traded per day. Thinly traded securities are illiquid and have higher spreads and volatility. When there is little interest and low trading volumes, the spread increases, causing the buyer to pay a price premium and forcing the seller into a price discount in order to sell the security. ETFs, for the most part, are immune to this. ETF liquidity is not related to its daily trading volume, but rather to the liquidity of the underlying assets in the ETF.

Broad-based index ETFs with heavily traded assets have very high liquidity. For narrow ETF categories, or even country-specific products that have relatively small amounts of assets and are thinly traded, ETF liquidity could dry up in severe market conditions, so you may wish to avoid ETFs that track thinly traded markets, have very few underlying securities, or small market caps in the respective index.

ETF long term viability?

A consideration before investing in ETFs is the potential that an ETF provider becomes insolvent. As more product providers enter the marketplace, the financial health and longevity of the sponsor companies will play a greater role. Investors should only invest in ETFs of well-established companies, to avoid forcing an unplanned liquidation of the funds. The results for investors who hold such funds in their taxable accounts could be an unwelcome taxable event. Unfortunately, it is next to impossible to gauge the financial viability of a startup ETF company, as many are privately held. As such, you should limit your ETF investments to firmly established providers to play it safe.

The Bottom Line

As more products are created, investors tend to benefit from increased choices and better variations of product and price competition among providers. It’s important to understand the differences between ETFs and mutual funds (even those which invest into the same assets), and how those differences may impact your investment process.