Mutual Funds v/s ETFs

One of the keys to successful investing is broad diversification. However, it’s hard for an individual investor to achieve broad diversification on their own. Purchasing a single share of every stock in the S&P 500 would cost over $80,000 today. That doesn’t even begin to get you market cap weighting, or exposure to any of the thousands of US and international stocks that aren’t included in the S&P 500.

Fortunately, investors have access to mutual funds and Exchange Traded Funds (ETFs), which are designed to solve exactly this problem. This article covers some of the important differences between those that every investor should know about, and concludes with a guide to follow when choosing whether to use a mutual fund or ETF.

Investment Trusts

Mutual funds and ETFs are both examples of investment trusts. Investment trusts allow investors to pool their assets in order to purchase assets that they wouldn’t have been able to on their own. The investment trust is collectively owned by the investors. The investment trust, in turn, may own a basket of assets. Individual investors effectively own a slice of each of those assets based on the portion of the investment trust that they own.

Mutual Funds

Mutual funds are operated by professional money managers who are responsible for investing assets in accordance with the fund’s investment policy.

Investors purchase and redeem mutual funds directly with the managers of the mutual fund. The managers are responsible for calculating a Net Asset Value (NAV) per share in the mutual fund, which is the price used in these transactions. The NAV is typically computed at the end of each trading day, and all transactions in the mutual fund typically take place after the markets have closed each day.

The NAV, or the value of each share of the mutual fund, is computed using the formula:

NAV = (Value of funds assets) / (number of outstanding shares)

Example

Let’s consider the example of a mutual fund that has the following holdings:

NAV = $509,320.00 / 10,000 = $50.932

In addition to the NAV, mutual funds may optionally also charge a “front-end load”, which is a fee assessed on each purchase transaction, and a “back-end load” or “deferred load”, which is a fee associated with redemptions. The platform the investor uses to purchase the mutual fund’s shares may also charge a trading commission.

ETFs

Like Mutual Funds, ETFs are also managed by professional money managers, own assets, and have shares that investors may own.

The key difference between mutual funds and ETFs is in how they are traded. As the name suggests, ETFs are directly traded (during the day) on exchanges, rather than being bought from and redeemed with the fund manager.

The price at which a share of an ETF is traded is based on market supply and demand of shares in that ETF. In theory, this could be very different from its NAV, so it’s possible to over- or under-pay for an ETF. In practice, most actively traded ETFs have market makers who ensure that the ETF trades very closely to its NAV.

ETFs don’t have transaction loads, but the purchase price of ETF shares is typically slightly higher than their NAV and sale prices are typically slightly lower than the NAV. This is also known as the “spread” and can represent a drag when trading any exchange-traded asset. Brokerages may also charge a commission for ETF trades.

Mutual Funds v/s ETFs

So what are some of the practical differences between mutual funds and ETFs from an investors perspective?

Fractional Ownership

Mutual funds typically allow investors to purchase and own fractional shares of the funds. ETFs typically do not. This means you can say something like “buy $10,000 worth of Mutual Fund X”, while, with an ETF, you would have to place an order to purchase the highest whole number of shares you could afford within your budget, and might have some money left over.

Some trading platforms do allow fractional ownership of stocks and ETFs. These are typically managed by the platform which holds the corresponding whole shares instead.

Automatic Investing

Somewhat as a corollary to fractional ownership, mutual funds allow automatic investing. This means that an investor could say “invest $500 in Mutual Fund X every month”, which is not possible with ETFs.

This also makes it easy to automatically reinvest dividends in a mutual fund. Some brokerages offer dividend reinvestment for ETFs also, but that usually also involves a remainder that’s left un-reinvested.

Time of Day

ETFs are traded during the trading day and can be traded multiple times during a day. Mutual funds, on the other hand, are typically only traded once a day, after markets close.

Loads, Spreads, NAV drift, and Commissions

Some mutual funds, including many of the ones sold by commissioned “financial advisors” have expensive loads. Fortunately, there are many excellent no-load mutual funds out there.

Some ETFs can have spreads as high as 3%. ETFs can also trade at prices very different from their NAVs. Fortunately, there are many popularly traded ETFs that don’t suffer from either of these problems.

Many brokerages charge no commissions on trades in ETFs these days. However, it’s more common for them to charge commissions as high as $75 on trades in “out of network” mutual funds.

Investors in mutual funds and ETFs would do well to pay attention to these factors when making trades in them.

Tax Efficiency

I saved the most important difference (from an investor’s perspective) for the end.

When investors redeem shares with mutual fund managers, that, in effect, reduces the number of outstanding shares in the mutual fund. Mutual funds typically maintain a cash reserve to pay off any net redemptions. However, if the value of the net redemptions causes the fund to go below its target cash reserves, the fund will sell some of its assets instead. In the example we used above, if half the outstanding shares were redeemed, the fund would sell off 500 shares of AAPL and MSFT each. Now, if those shares had appreciated in value since the mutual fund had purchased them, this would result in the fund realizing a capital gain from the sale. Because of the tax treatment of mutual funds, this capital gain is incurred by all shareholders in the fund, not just the ones making redemptions. The result of this is that holders of mutual funds typically see annual reported capital gains distributions. These distributions, and the resulting taxes, can impose a drag on the investors portfolio growth by reducing the amount of capital they have to invest.

Most ETF trades are just shares changing hands between investors, and don’t involve creating or destroying shares. ETF managers don’t typically need to sell assets to cover redemption costs. Even in a situation where ETFs do need to create or destroy shares, this happens through a process where the ETFs exchange cash for a basket of securities. This is treated by the IRS as an “in kind” transaction and doesn’t result in a capital gain distribution.

As a result of this, ETFs are much more efficient than Mutual Funds. Investors should avoid holding Mutual Funds in taxable accounts for this reason.

The Tax-Efficiency of Vanguard Mutual FundsVanguard, since 2001, has maintained a unique dual class structure for most of its mutual funds, where the corresponding ETFs are considered a share class of their equivalent mutual funds. Redemptions of Vanguard mutual funds are handled as a transaction with the corresponding ETF. This allows Vanguard mutual funds to share a lot of the tax efficiency characteristics of ETFs.

Unfortunately, Vanguard has patented this method, preventing other fund managers from implementing a similar dual class structure.Fortunately, that patent expires this month (May 2023).Unfortunately, the SEC, which granted Vanguard an exception for its method, has, so far, refused to allow other fund managers to implement a similar structure. The result of this is that mutual funds not managed by Vanguard will continue to remain inefficient from a tax standpoint.However, this method is not a panacea. In 2021, Vanguard launched new, lower priced, institutional class shares for many of its target date funds as separate funds. This resulted in a large number of redemptions to facilitate an exchange for the new lower cost institutional class shares. The net result of this was that investors who held Vanguard target date funds in taxable accounts were surprised with capital gains distributions ranging from 3% to 15% that year.

How do I apply all this?

You can use the following table as a guide when choosing between a Mutual Fund or ETF

Do a quick audit of all your taxable accounts. If you see any mutual funds in there, you might want to consider exchanging them for their ETF equivalents. However, you should also be conscious of the tax implications of this exchange. Depending on your tax bracket, investment horizon, and the extent of the gains, you might not want to do this with any mutual funds that have accumulated substantial unrealized gains.

Questions? Comments? Feel free to reach out to me at suhas@prosperowealth.com if you would like to discuss this, or your personal situation, further.