The first time someone described an Exchange Traded Fund (ETFs) to me, I thought, “Wow, that sounds a lot like a mutual fund!” Both ETFs and mutual funds are viable choices for investors. It’s important for investors to understand that ETFs and mutual funds share some similar characteristic, but they also have marked differences.
An ETF is a pool of investments that gives instant access to various markets and broad diversification. And, like a mutual fund, ETFs also issue and redeem shares at market-based prices to investors. So, what makes an ETF different from a mutual fund?
What Are the Five Differences between ETFs and Mutual Funds?
While there are several distinctions between ETFs and Mutual Funds, most fall into one of the following five categories: (Trading, Expenses, Tax Treatment, Liquidity, Survivability)
1. Trading Process
The primary difference between the two is related to the way investors transact the shares of the fund.
In the case of a mutual fund, investors transact with the mutual fund directly, buying and selling shares at a net asset value, which is calculated by the fund once a day.
With an ETF, investors transact with other investors (not the fund) by buying and selling shares on an exchange at market prices, like stocks. As investors buy and sell, those transactions meet on an exchange with the help of market makers. At the end of the day, the market maker ends up either having a net short position or a net long position of shares bought and sold, and will offset those positions by creating new shares or redeeming existing shares.
Translation: ETFs allow for trading throughout the day, whereas mutual fund transactions will only occur when the mutual fund manager calculates the net asset value calculation, which occurs once a day.
Due to the passive nature of indexed strategies, the internal expenses of most ETFs are considerably lower than those of many mutual funds. Of the more than 1,900 available ETFs, expense ratios range from about .005% to 1.25%. By comparison, the lowest mutual fund fees range from .01% to more than 10% per year for other funds.
Another expense that should be considered is the cost of acquiring the product. Mutual funds can often be purchased at NAV, or in every day parlance, stripped of any loads. However, many (they are often sold by an intermediary) have commissions and loads associated with them. Some of these commissions or loads can run as high several percentage points. ETF purchases are free of broker loads.
3. Tax Efficiency
ETFs can offer tax advantages to investors. As primarily passively managed portfolios, ETFs (and index funds) tend to realize fewer capital gains than actively managed mutual funds. ETFs also create better tax efficiency, because of the way they are created and redeemed. For example, suppose that an investor redeems $25,000 from a traditional S&P 500 fund. To pay that to the investor, the fund must sell $25,000 worth of stock. If appreciated stocks are sold to free up the cash for the investor, then the fund realizes that capital gain, which is distributed to shareholders before year-end. Thus, shareholders of that fund pay the taxes for the turnover within the fund. If an ETF shareholder wishes to redeem $25,000, the ETF doesn’t sell any stock in the portfolio and doesn’t create the same sort of capital gains impact for the shareholders.
Liquidity is 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 to get the security sold. 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 stocks included in the index.
Broad-based index ETFs with significant assets and trading volume offer more 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 steer clear of ETFs that track thinly traded markets.
5. ETF Survivability
A consideration before investing in ETFs is the potential that fund companies will not last. As more product providers enter the marketplace, the financial health and longevity of the sponsor companies will play a greater role. Investors should not invest in ETFs of a company that offer the likelihood to prematurely disappear, thereby 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, it may be smarter to limit ETF investments to firmly established providers or market dominators to play it safe.
As new products are rolled out, 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, and how those differences may impact the performance of your investment choices. Make sure to review the five primary differences discussed above when deciding between ETFs and mutual funds.
This information is not intended to provide specific tax, legal or business advice and may not be relied upon for the purpose of avoiding any tax penalties. Lewer Financial Advisors is a multi-state registered investment advisor domiciled in Missouri. Lewer Financial Advisors is a member of the Lewer group of companies.