Fun with Funds – Mutual Funds vs. Exchange Traded Funds (ETFs)
Understanding the Differences
With the proliferation of sources for financial information and education today, more and more investors are taking their financial destiny into their own hands and making investment decisions for themselves. Traditionally however, Mutual Funds were the most well known investment tools on the block. However, although they've been around since the early 1990's, Exchange Traded Funds (or ETFs) are fast gaining popularity.
This article seeks to educate and help prospective investors understand the main differences (and similarities) between the two.
Same, but Different
In their most basic form, both instruments (Mutual Funds and ETFs) represent "a basket" of investment products. Generally, the basic unit of investment are stocks or bonds of a corporation. However, the companies owning these instruments build specific investment portfolios by knitting together a broad array of stocks and bonds to create a Mutual Fund or an ETF. Because of this "basket" of products characteristic, when you buy a single Mutual Fund or ETF you could actually be investing in many companies instead of just one.
Subsequently, Portfolio Managers can use the single Mutual Fund or ETF so created, to then produce more complex structures of "Funds within Funds" and "ETFs within ETFs". This structure of Mutual Funds and ETFs therefore delivers somewhat of an instant diversification to any portfolio because, unlike holding a single company's stock or bond, a single Fund allows you to participate in a much broader market.
And that's where the major similarity between the two products ends!
The Differences – Mutual Funds vs. ETFs
The two types of Funds have more differences than similarities, and here are some that investors should consider when making informed investment decisions:
Price: When you check the price of a stock before buying it, what you are looking at is what the stock is trading at today (in real time). Barring a difference due to Bid/Ask spreads and trading commissions and Exchange fees, the price you see is what you are likely to pay. The same is true for ETFs. They trade just like a stock.
Mutual Funds are however not traded based on current prices. Instead, their values are determined by a parameter known as the Net Asset Value (or NAV), which is calculated at the end of each trading session. Therefore, you may not be able to figure out exactly what the cost of your purchase is until the next day, when the NAV is re-calculated.
Costs: In general, because most ETFs are not actively managed (only 1% of the existing $1.4 trillion worth of Exchange Traded Funds is actively managed). There is less cost associated with owning an ETF as opposed to most Mutual Funds, where Management Expense Ratio (MERs) can sometimes be in the high single digits.
Management Expenses are the fees charged by the management firm that manages and balances the Mutual Fund. Most Mutual Funds include front or back-end loads (although there are no-load Mutual Funds too) that add to their cost. Front-end load refers to up-front/front end fees that you have to pay when investing in the fund, while back-end loads refer to fees paid later. ETFs on the other hand do not have those costs associated with them.
Taxation: Because of the way ETFs are structured, they do not automatically trigger a Capital Gain if they are sold at a premium to the cost at which the buyer purchased the ETF. That's because when you "sell" your units, they are not really "sold" but rather "exchanged" within the overall ETF. This therefore eliminates a Capital Gain tax that would normally occur in similar case when a stock or a Mutual Fund is sold. In that respect, ETFs are more tax-efficient.
Be aware however that, because of this internal "exchange" mechanism within an ETF, there may be cases where the overall ETF incurs a Capital Gain due to turnover of its units, even though an individual investor hasn't sold his/her units. At the end of the year, that gain will be "shared" by all ETF unit holders, and that could potentially trigger a Capital Gain tax on an individual's ETF holdings.
In general terms, it's not true that ETFs are better than Mutual Funds, or vice versa. It all depends on what your individual investment objectives are, and how well diversified your investment portfolio is. Depending on these two criteria, and how well you educate yourselves about Mutual Funds and ETFs, the average investor is likely to find products in both categories that may appeal to their unique financial situation.
Good luck in your investing,
MarketConsensus Stock Analysis Team
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