Mutual funds vs. ETFs: an overview
Mutual funds and exchange traded funds (ETFs) have a lot in common. Both types of funds are made up of a mix of many different assets and are a common way for investors to diversify. There are, however, major differences in the way they are handled. ETFs can be traded like stocks, while mutual funds can only be bought at the end of each trading day based on a calculated price. Mutual funds are also actively managed, which means that a fund manager makes decisions about how to allocate assets in the fund. ETFs, on the other hand, are generally managed passively and more simply based on a particular market index.
According to the Investment Company Institute, there were 8,059 mutual funds with a total of $ 17.71 trillion in assets as of December 2018. This compares to ICI research on ETFs, which reported a total of 1,988 ETFs with $ 3.37 trillion in combined assets for the same period.
Key points to remember
- Mutual funds are generally actively managed to buy or sell assets within the fund with the aim of beating the market and helping investors profit from it.
- ETFs are mostly passively managed, as they typically track a specific market index; they can be bought and sold like stocks.
- Mutual funds tend to have higher fees and expense ratios than ETFs, which reflects, in part, the higher costs of active management.
- Mutual funds are either open-ended: exchanges take place between investors and the fund and the number of available shares is unlimited; or with fixed capital: the fund issues a defined number of shares regardless of investor demand.
- The three types of ETFs are exchange traded open-ended index mutual funds, unit-linked investment trusts, and grantor trusts.
Mutual funds generally have a higher minimum investment requirement than ETFs. These minimums may vary depending on the type of fund and company. For example, the Vanguard 500 Index Investor Fund requires a minimum investment of $ 3,000, while the Growth Fund of America offered by American Funds requires an initial deposit of $ 250.??
Many mutual funds are actively managed by a fund manager or team that decides to buy and sell stocks or other securities within that fund in order to beat the market and help their investors grow. To take advantage of. These funds usually have a higher cost because they require much more time, effort and manpower.
The purchases and sales of mutual funds take place directly between the investors and the fund. The fund price is not determined until the end of the business day on which the net asset value (NAV) is determined.
Two types of mutual funds
There are two legal classifications for mutual funds:
- Open funds. These funds dominate the mutual fund market in terms of volume and assets under management. In the case of open-ended funds, the buying and selling of fund units is done directly between the investors and the fund company. There is no limit to the number of shares that the fund can issue. So, as more and more investors buy into the fund, more shares are issued. Federal regulations require a daily valuation process, called mark-to-market, which then adjusts the fund’s share price to reflect changes in the value of the portfolio (asset). The value of an individual’s shares is not affected by the number of shares outstanding.
- Closed-end funds. These funds only issue a specific number of shares and do not issue new shares as investor demand increases. Prices are not determined by the net asset value (NAV) of the fund but are determined by investor demand. Purchases of shares are often made at a premium or a discount to the net asset value.
It is important to take into account the different fee structures and the tax implications of these two investment choices before deciding if and how they fit into your portfolio.
Exchange Traded Funds (ETFs)
ETFs can cost a lot less for an entry position, as little as the cost of a stock, plus fees or commissions. An ETF is created or redeemed in large lots by institutional investors, and stocks trade throughout the day between investors like a stock. Like a stock, ETFs can be sold short. These provisions are important for traders and speculators, but of little interest to long-term investors. But since ETFs are continuously valued by the market, it is possible that trading will take place at a price other than the true net asset value, which may introduce an arbitrage opportunity.
ETFs offer tax advantages to investors. As passively managed portfolios, ETFs (and index funds) tend to realize less capital gains than actively managed mutual funds.
ETFs are more tax efficient than mutual funds because of the way they are created and redeemed.
Example of mutual fund versus ETF
For example, suppose an investor redeems $ 50,000 from a traditional Standard & Poor’s 500 Index (S&P 500) fund. To pay the investor, the fund must sell $ 50,000 of shares. If appreciated stocks are sold to free up money for the investor, the fund captures this gain, which is distributed to shareholders before the end of the year. As a result, shareholders pay taxes on turnover within the fund. If an ETF shareholder wishes to buy back $ 50,000, the ETF does not sell any shares in the portfolio. Instead, it offers shareholders “in-kind redemptions,” which limit the ability to pay capital gains.
Three types of ETFs
There are three legal classifications for ETFs:
- Exchange traded open-ended index mutual fund. This fund is registered under the SEC’s Investment Company Act of 1940, under which dividends are reinvested on the day of receipt and paid to shareholders in cash quarterly.Securities lending is permitted and derivatives may be used in the fund.
- Exchange-Traded Unit Investment Trust (UIT). Exchange-traded ITUs are also governed by the Investment Company Act of 1940, but they must attempt to fully replicate their specific indices, limit investments in a single issue to 25% or less, and set additional weighting limits. for diversified and non-diversified funds. .ITUs do not automatically reinvest dividends, but pay cash dividends on a quarterly basis. Some examples of this structure include the QQQQ and the Dow DIAMONDS (DIA).
- Exchange Traded Grantor Trust. This type of ETF looks a lot like a closed-end fund, but an investor owns the underlying stocks of the companies in which the ETF is invested. This includes having the voting rights associated with being a shareholder. However, the composition of the fund does not change. Dividends are not reinvested, but are paid directly to shareholders. Investors should trade in lots of 100 shares. Holding company certificates of deposit (HOLDR) are an example of this type of ETF.