ETFs or Mutual Funds? Exchange Traded Funds (ETF) and Mutual Funds (MF) are investment vehicles that pool multiple securities into one fund, allowing investors like you and I to diversify efficiently. These funds have become so popular that they account for more than $20 trillion in assets*. That $20 trillion has been more than enough market share to breed healthy competition between fund providers. So how do we capitalize on this competition to maximize our investment return potential? We learn the differences between ETFs and MFs that are material to our wallet. These differences are costs and operations. The costs are specific to each fund and the operational differences are specific to the type of vehicle.
Costs are of the utmost importance when choosing between similar MFs, ETFs, or a combination of the two. Always remember your returns aren’t guaranteed but your costs are. Because you will always pay the costs associated with your investment, regardless of the return, you must know how to identify and evaluate them. Costs can be broken down into two groups, transactional and ongoing.
Transactional costs are the fees paid when you buy or sell an investment. These fees mostly include commissions, front and back end loads, and any other one-time fees. When comparing a similar ETF and MF, list out these one-time transactional costs and see if one fund comes out cheaper. For example, does one fund have a load while the other does not? Does one fund have a five percent load but the other is only two percent load? Even better yet, there are actually ETFs and MFs available that do not have any transactional costs. Try finding these investments and eliminate this analysis entirely
Ongoing costs are the fees paid by you, the investor, throughout the time you hold the investment. These costs are typically referred to as management fees or expense ratios and are taken directly out of the fund. These ongoing fees mostly include record keeping, custodial services, legal expenses, accounting, auditing, 12b-1 (marketing), and advisory fees. The ongoing fees are typically lumped together and shown as a percentage of assets. For example, if the fund’s annual expense ratio is 1.0%, the yearly ongoing fees of that fund are equal to one percent of the fund’s total assets. The average yearly ongoing fee for ETFs and MFs is between 1.3-1.5%**. However, if you are doing your homework you can do much better than that. If you do decide on a fund with a higher than average fee, make sure you have a good reason, i.e. the fund’s manager has shown a history of outperforming the market thus the manager is worth the additional cost.
When you are comparing between similar funds you may find that one does not stand out in terms of costs. If you find yourself in this situation you will need to estimate your time horizon. If you hold the investment for a long period of time, the ongoing fees become more important and the transactional costs less important. And if you plan to hold the investment for a short period of time then the transactional costs will likely be more important. In order to help quantify the costs in accordance with your time horizon, you can use our Similar Fund Comparison Tool, contact us for the tool.
ETF and MF Operational Differences
Mutual funds and ETF’s have the same goal but achieve it differently. Think of them like mini-vans and pickup trucks; both will get you from point A to point B, but which is right for you depends on your unique situation.
If minimizing your tax liability is important, ETFs have a distinct edge. This edge is explained through how ETFs and MFs grow and shrink to fit investor demand. MFs re-balance and calculate their net asset value (NAV) once each day while ETFs use a creation/redemption process. This is important because when MFs re-balance they buy and sell securities. This buying and selling of securities trigger a taxable event split among all owners of the fund, not just the investors selling or buying shares. ETFs do not have this issue. When they create or redeem shares the taxable event is limited to the investor making the transaction. Thus, you only pay taxes on transactions that you make. MFs do have another option to avoid taxable events, which is to hold a portion of the investment in cash. This reduces the Fund’s need to buy and sell securities each time an investor buys or sells the fund. The unfortunate drawback is that this creates a cash drag. Either way, ETFs have an advantage over MFs in how they grow and shrink with investor demand.
So when do taxes matter? They matter when your investments are not in a tax-deferred account such as an IRA or 403(b). These accounts allow you to defer paying capital gains. If your investment is not in a tax-deferred account, then taxes matter because you will be paying them yearly. This yearly tax cost can materially reduce your investments ability to compound.
Mutual funds may be the better choice for you if taxes are not concerning and you are more interested in the efficient re-investment of dividends. ETFs must hold onto their security dividends in cash before paying them out to the shareholders. These payouts happen at specific dates a few times throughout the year. Mutual funds have the option to reinvest their dividends immediately. This allows mutual funds to eliminate dividend cash drag and get money back into the market (that is, its underlying securities.)
In conclusion, when choosing between similar funds, cost is king. When choosing between similar mutual funds or a combination of MFs and ETFs, compare their costs. If one does not stand out, use the Similar Fund Comparison Tool. If you’re still undecided after the costs analysis, look at your tax situation and see whether you can take advantage of the ETF’s tax edge.
Transactional Costs – The cost incurred when buying or selling the product. This is a one-time fee.
Ongoing Costs – (Management Fee or Expense Ratio) – The costs to operate the fund passed through to the investors. This is an annual percentage automatically deducted from your investment.
Vehicle Differences (ETF vs. MF)
ETF Advantage = Tax Efficiency
Mutual Fund Advantage = Dividend Policy