Understanding Mutual Funds and ETFs

December 6, 2019

 

Understanding Mutual Funds and ETFs
By Tim Courtney, Chief Investment Officer

Several large brokerage houses made headlines earlier this fall when they announced zero fees for stock and ETF trading. Firms such as Charles Schwab, TD Ameritrade and Fidelity were on the list among others.1 However, while trading costs have lessened for ETFs, not much has changed for mutual funds.

At Exencial, we trade relatively infrequently. When we do recommend trades it is usually for strategic reasons such as tax loss harvesting or rebalancing. However, now that the trading of ETFs is very cost effective, it’s important to understand the difference between an ETF and a mutual fund and why one may make sense over the other.


Mutual funds: At $18 trillion in assets and counting, mutual funds continue to be a popular investment choice for U.S.-based investors.2 We have traditionally invested in relatively low-cost and low-turnover mutual funds. They are bought and sold at the end of the trading day based on the net asset value (NAV) or “fair price” of the fund. That end of day share price reflects the value of all of the holdings within the fund. Mutual funds pay out interest, dividends, and potentially realized gains at the end of the year.3


ETFs: There is over $4 trillion in assets invested in ETFs in the U.S.4 Though they still have a long way to go to overtake mutual funds in asset size, ETFs are quickly gaining steam. Unlike mutual funds, ETFs are bought and sold throughout the day (similar to stocks), and immediate pricing is determined by supply and demand. While ETFs pay out dividends, they do not make distributions from gains realized within the fund, which can make them more tax-efficient and more attractive for taxable accounts such as trusts.5

Both mutual funds and ETFs have advantages and disadvantages. ETFs are cheaper to trade and are in most cases more tax-efficient. While there are mechanisms in place that generally keep market ETF prices close to their “fair price” NAV, prices can move meaningfully away from the NAV at times (e.g. the Flash Crash of 2015).6  This is especially true for ETFs that have lower share trading volume.

Mutual funds can allow managers more flexibility in the daily trading of underlying positions since they don’t have to be priced throughout the day. The other side of this though is that you can’t buy mutual funds intraday, and they often don’t offer exposure to smaller or more esoteric areas of the marketplace like some ETFs do.

At this stage, both investment vehicles should be considered when building your portfolio. If you have any questions about the mechanics of mutual funds versus ETFs, please contact your advisor.

Sources:

1. CNBC – Battle for client assets heats up as brokers cut fees to zero
2. Nasdaq – 18 trillion reasons to like mutual funds
3. Investopedia – Mutual fund
4. ETF.com – US ETF assets hit new milestone
5. Investopedia – What is an ETF?
6. Investopedia – The two biggest flash crashes of 2015

 

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