Exchange-Traded Funds (ETFs) vs Mutual Funds; Differences, Pros and Cons

Capison Pang

Exchange-traded funds (ETFs) vs. mutual funds is a worthy topic for debate, since both give investors access to the financial markets that offer an excellent way for individuals to save for college or retirement, grow their income or protect against inflation.

However, the global markets, as well as the pros and cons of exchange-traded funds (ETFs) vs. mutual funds can be a complex and confusing mechanism for the average investor. Thankfully, there are options for individuals looking to quickly build a diversified portfolio or gain access to professional investment management services. Due to their numerous advantages, two of the most common financial instruments used are exchange-traded funds (ETFs) and mutual funds.

Exchange-Traded Funds (ETFs) vs. Mutual Funds: Both Feature Diverse Holdings

ETFs and mutual funds are portfolios of collectively held securities. The average mutual fund encompasses over 100 different securities. ETFs can range from a few dozen to a few thousand securities. ETFs and mutual funds are designed to contain securities from specific industries or sectors, asset classes, styles and market capitalizations (market cap) to help individuals select investments based on their risk tolerance. 

By bundling these securities together, ETFs and mutual funds allow individuals to not only participate in the financial markets more easily but reduce risk and volatility by varying their investments. By diversifying their portfolio, investors can hedge their investments to downward swings. An industrial stock can drop 15% overnight, while the sector as a whole barely drops 3%, if it at all.

Although on the surface, mutual funds and ETFs can appear to be nearly identical, each investment vehicle brings about unique pros and cons that need to be considered for each investor.

Exchange-Traded Funds (ETFs) vs. Mutual Funds: ETFs Have Become Popular

Since being first introduced in 1993, exchange-traded funds have become an ever more popular option for investors looking to quickly and efficiently diversify their portfolio. Compared to other investment funds, ETFs’ liquid and cost-effective nature provide an enticing opportunity for many individuals, especially for those just beginning to delve into the global financial markets. Today, there are approximately $7.74 trillion held across 7,602 different ETFs globally.

Exchange-traded funds are created by a prospective ETF manager, who borrows securities, likely from a pension fund, to place in a trust. The borrowed securities are then used to form creation units. Creation units are packages of 10,000 to 600,000 securities. ETFs are constructed from tiny slivers of the different creation units. Finally, shares of the ETFs provided by the trust are then sold on the open market, similar to shares issued by a company. The underlying trust has little movement beyond administrative oversight and dividend payments to the various ETF shareholders.

Since the underlying securities of an ETF are held in trust in a creation unit, owning an ETF share does not correlate to the direct ownership of securities. Unless an individual amasses the thousands of ETF shares needed to match and cash out a creation unit for its underlying securities — usually only undertaken by institutional investors — an investor cannot simply redeem an ETF share for the securities held in trust. Instead, an ETF share serves as a legal claim on the securities held in trust.

Exchange-Traded Funds (ETFs) vs. Mutual Funds: ETFs Offer Real-Time Pricing

Uniquely, the shares of an ETF are liquid enough for intraday trading on exchanges or over-the-counter (OTC), something not available for most other investment fund shares. Intraday trading also allows for ETF shares to be shorted or purchased on margin. However, this liquidity can create price misalignments. An ETF share can end up trading slightly higher or lower than its underlying securities. Although this may seem problematic to the average investor, any discrepancies that arise are quickly captured by arbitrage traders, which move the ETF share price back into sync with its underlying securities.

Traditionally, ETFs were designed to be passive investments. However, since being introduced in 2008, active ETFs have begun to gain significant ground in recent years, although passive ETFs remain much more common. The difference between the two lies in how the underlying securities are managed and the resulting expense ratio.

Passive ETFs are designed to track an index or a popular benchmark, such as the S&P 500, Dow Jones Industrial Average or a specific industry or sector. ETFs of this type do not seek to outperform the market or its benchmark and are great for investors looking to invest in a particular industry, sector or index. The ETF automatically adds or drops securities from its portfolio to match the index or benchmark they are assigned to emulate. As a result, passive ETFs do not offer the same professional guidance or support as other funds but charge lower fees. The average passive ETF expense ratio is 0.13%, meaning that for every $100 under management, 13 cents is paid to the fund manager.

Exchange-Traded Funds (ETFs) vs. Mutual Funds: Active ETFs Differ from Index ETFs

On the other hand, active ETFs attempt to beat the market through a team of analysts and professionals who continuously monitor the markets to select securities for the portfolio. ETFs of this type will typically have a particular index or benchmark they will track loosely. However, the fund manager will have the authority to deviate from the index or benchmark. An active ETF provides consistent professional oversight and stock analysis but also charges higher fees than passive ETFs. The average expense ratio of an active ETF stands at 0.66%. Outside of the fees and stock selection process, active and passive ETFs’ underlying structure and characteristics remain the same.

Most exchange-traded funds set investment parameters beyond just the industry or sector they follow. The three most common parameters are asset class (equity, bond, commodity, currency, etc.), style (value, growth and blend) and company size (mega-cap, large-cap, mid-cap, small-cap, etc.). These three classifications allow individuals to better sort various ETFs by different risk profiles and potential return rates. Learn more about the various asset classes, styles and market cap classifications here.

Of course, there are drawbacks to every financial instrument. Intraday trading can be a double-edged sword for investors as short-term speculation on ETF shares can raise commissions and trading costs. Leveraged ETFs, which use debt to multiply returns, can also bring about losses several times the initial investment. Learn more about leveraged ETFs here.

One of the more common issues in ETFs for investors is the inconsistencies they bring regarding diversification. Many ETFs track benchmarks with narrow specifications, such as large-cap communications stocks, which reduce portfolio diversification.

Exchange-Traded Funds (ETFs) vs. Mutual Funds: How ETFs Produce Returns

In the end, what matters most for investors is how they can earn returns. There are three primary ways retail ETF investors can earn a profit: dividend payments, capital gains distributions and an increased market value.

  1. Dividend payments arise from the income generated by interest and dividend payments from the various bonds or stocks held in the ETF portfolio. ETFs typically hold onto all dividends received from their various underlying securities before paying them in full at the end of each quarter on a pro-rata basis.
  2. If the ETF sells an underlying security at a profit, the fund achieves a capital gain. At the end of the year, the ETF will distribute all capital gains it has collected minus any capital losses to investors.
  3. Investors can sell their ETF shares at a profit during intraday trading if the underlying securities in the trust increase in market value.

In short, exchange-traded funds are great investments for individuals looking for a cheap and efficient way to diversify their portfolios quickly. ETFs are backed by an underlying set of securities held in a trust and can be actively or passively managed. Passive ETFs look to capture a particular index or benchmark as closely as possible and do not seek to outperform the market.

Active ETFs treat their index or benchmark as a rough guideline and look to beat the market by selectively choosing and picking securities. Unlike most other investment funds, ETFs are liquid enough to be traded intraday on exchanges or OTC, allowing shares to be shorted or bought on margin. However, like with any investment fund, an individual needs to understand the parameters of a potential ETF investment. How narrow is its investment benchmark? Is it a leveraged ETF?

For a more comprehensive overview of ETFs, click here.

Exchange-Traded Funds (ETFs) vs. Mutual Funds: Mutual Funds Remain the Kings

Mutual funds are the kings of the investment fund world. Invented in 1924 and holding over $54.93 trillion across 126,500 funds globally, mutual funds are among the oldest and most popular investment vehicles for individuals seeking professional guidance to diversify their portfolios.

Most mutual funds are part of a much larger company, which owns and operates up to hundreds of different funds and other investment vehicles. Some common examples of companies are The Vanguard Group, BlackRock (NYSE:BLK) and Fidelity Investments. However, each individual mutual fund acts as an independent entity.

The idea behind a mutual fund is simple. It pools capital from investors to build a diverse portfolio of securities. Similar to exchange-traded funds, mutual funds can be passively or actively managed. Passive mutual funds are also known as index funds, discussed more in-depth here. When experts mention mutual funds, they are commonly referring to actively managed mutual funds. We will follow the same norm here.

Mutual funds raise capital by issuing shares to investors, which represents a stake in the portfolio and its returns. Mutual funds are open-ended funds, which means fund managers can issue new shares at any time. As long as there is a demand for shares in a fund, new shares will be issued.

Exchange-Traded Funds (ETFs) vs. Mutual Funds: Real-Time vs. End-of-Day Pricing

Individuals can only buy and sell mutual fund shares from/to the fund itself or a broker for the fund. The share price at the time of buying/selling is determined by the fund’s net asset value (NAV) per share, along with any fees. Since the portfolio’s value is only priced at the end of trading, transactions can only occur at the end of each business day. 

Unlike an ETF, the buying and selling of mutual fund shares impact the portfolio’s size. When investors buy into a mutual fund, the portfolio size increases proportionately. If investors cash out their mutual fund shares, the portfolio decreases in size proportionately. 

In rare situations, a mutual fund may provide in-kind redemptions. Instead of cash, the fund will pay investors in securities or property. In-kind redemptions usually only occur when a fund is experiencing significant net outflows of capital.

Mutual fund investors can turn a profit through the dividend or interest payments from the underlying securities, capital gains distributions and by cashing out the mutual fund shares if the portfolio increases in value.

A fund acts as both an investment vehicle and an actual company. When an investor buys an Amazon stock, he owns a piece of the company. The same idea occurs when an individual purchases a share of a mutual fund. However, instead of selling books or laptops, mutual funds are in the business of investing. 

Exchange-Traded Funds (ETFs) vs. Mutual Funds: What are the Types?

Most mutual funds fall into four categories: money market funds, bond funds, stock funds and target-date funds. 

  1. Money market funds are considered low risk. They are required by law to invest only in select short-term, high-quality investments issued by U.S. corporations and governments.
  2. Bond funds consist of various fixed-income instruments issued by corporations and governments. 
  3. Equity funds invest in stocks from publicly held companies. Funds of this type can invest based on growth, income (dividends) or a blend of the two.
  4. Target date funds hold a mix of various securities, which shift to adjust for risk and return as the fund approaches the target date. These funds are great for individuals with a specific retirement date in mind.

Similar to ETFs, mutual funds can invest in or across specific industries or sectors, asset classes, styles or market caps. Since mutual funds are active investment funds, a fund manager and a team of analysts will continually analyze securities to determine the best potential investments for the portfolio to beat the market. As a result, mutual funds generally do not follow a particular index or benchmark. However, some mutual funds will focus on a specific economic sector (health care, technology, communications, etc.).

In return for a dedicated management team, mutual funds generally charge higher fees than both active and passive ETFs and often possess minimum investment requirements. The average expense ratio for a mutual fund is between 0.5% and 1.0%. Retail mutual funds typically also carry a $1,000 to $5,000 investment minimum.

Exchange-Traded Funds (ETFs) vs. Mutual Funds: What are the Fees?

Mutual funds typically charge shareholder fees that do not exist with ETFs. The different fee structures can significantly impact potential returns, so it is vital to get a good understanding of them:

  1. Sales Charge (Load) on Purchases, also known as a front-end load, is a fee that occurs when an investor buys mutual fund shares, usually paid to the fund’s broker. A front-end load reduces an individual’s investment amount.
  2. Purchase Fees are similar to front-end loads, but instead of going to a mutual fund’s broker, it is paid directly to the fund managers. Purchase fees are typically found in funds with high investment transaction costs.
  3. Deferred Sales Charges (Load), also known as back-end loads, are the opposite of front-end loads and usually occur in contrast to one another. Back-end loads are charged when an investor cashes out his fund shares. Often, the longer an investor holds onto a mutual fund share, the smaller the back-end load.
  4. Redemption Fees are back-end fees that are paid to the fund managers instead of the fund broker. Redemption fees are capped at 2% by law.
  5. Exchange Fees can occur when an investor transfers his investment to another mutual fund in the same fund group or family of funds.
  6. Account Fees are account maintenance fees.

Exchange-Traded Funds (ETFs) vs. Mutual Funds: What are the Classes?

A unique aspect of mutual funds is that they can issue different classes of shares. While ETFs can only have one category of shares, mutual funds may offer multiple share classes to allow for more investment flexibility. Each class invests in the same portfolio and shares using the same investment objective and strategies but provides different fee, expense and distribution arrangements. Different share categories will typically also offer differing shareholder services. 

The number of share classes and the characteristics for each class will vary from fund to fund. Generally, Class A shares are front-end loaded, while Class B shares are back-end loaded.

In short, mutual funds allow investors to diversify their investments while gaining access to professional stock selection and portfolio management services. Shares for mutual funds can only be bought and sold at the end of the day and only from/to the fund and its designated broker. The buying/selling price of a mutual fund’s share is determined by the fund’s NAV per share, alongside any fees. Funds can issue multiple share classes, each with different benefits and costs.

Exchange-Traded Funds vs. Mutual Funds: Differences Between the Two

Although on the surface, the difference between mutual funds and exchange-traded funds appear to be minimal, especially between actively managed ETFs and mutual funds, the minor discrepancies drastically change the game for investors.

Mutual funds are actively managed and are not associated with a particular benchmark or index. Passive ETFs follow a set benchmark or index and do not attempt to beat the market. Active ETFs are generally associated with a benchmark or index that acts as a rough guideline from which the fund can deviate. Mutual funds and active ETFs aim to beat the market through selective stock picking by a portfolio manager and his team of analysts.

Since active and passive ETF shares are liquid enough to be bought and sold on exchanges or OTC, it allows investors to conduct intraday trading and short ETF shares or purchase them on margin. For most long-term investors, the difference between intraday and end-of-day trading is minimal, but some individuals require greater flexibility. The underlying securities of an ETF are held in trust and experience little movement despite the market activity. ETF shares can only be redeemed when an individual accumulates enough shares to cash out a creation unit.

Mutual fund shares must be bought from the fund or through the fund’s broker. Mutual fund shares can also only be sold back to the mutual fund or the fund’s broker. The buying and selling of mutual fund shares occur only at the end of the trading day. The price is determined by NAV per share, along with any fees. When investors buy or sell mutual fund shares, the mutual fund portfolio size increases or decreases proportionately. In rare cases, mutual funds may provide in-kind redemptions.

Exchange-Traded Funds (ETFs) vs. Mutual Funds: Earning Returns

An investor can earn returns from ETFs through dividend and interest payments from the underlying securities, through capital gains when the ETF sells an underlying security for a profit, or sells ETF shares on exchanges or OTC after they rise in value.

Mutual fund investors earn returns in the same way. The one exception is that they must sell shares back to either the fund or fund broker.

Exchange-traded funds are more tax-efficient than mutual funds. When a mutual fund investor cashes out his shares, the fund manager may issue new shares to raise capital to make up the difference. The sale of new shares can result in realized capital gains, leading to an increased tax bill that is ultimately spread across all investors in the fund, even for those that did not sell any shares. Since ETF shares are traded in the secondary market, an investor’s tax consequences are a product of their own actions.

In terms of fee structure, passive ETFs are the cheapest, active ETFs provide a middle option and mutual funds are the most expensive. Mutual funds also often require minimum investment amounts. 

When is it Better to Invest in Exchange-Traded Funds (ETFs)?

Although holding fewer global investments than mutual funds, exchange-traded funds have become more and more popular over the years. Since 2010, global ETF assets have experienced a compound annual growth rate (CAGR) of 19.4%, from $1.31 trillion to $7.74 trillion.

The benefits of ETF investing are apparent, allowing a choice between passive and active investing, lower fees, no minimums, a lower tax bill and trading shares on exchanges and OTC. It is no wonder that ETFs have seen a massive surge in popularity in recent decades.

ETFs are better for investors looking for lower fees and minimums. ETFs are especially great for individuals with only a few hundred or a few thousand dollars to invest since there are no minimums and low fees. Especially for investors looking for continuous professional securities analysis, active ETFs provide a cheaper and more liquid option than mutual funds.

Exchange-Traded Funds (ETFs) vs. Mutual Funds: Consider Hands-on Control

ETFs are also better for investors looking for more hands-on control over the buying and selling of shares. By enabling intraday trading, ETFs allow investors to receive real-time pricing of shares and execute complex trade maneuvers (stop orders, limit orders, etc.) not available to mutual fund shareholders.

Finally, ETFs are for investors looking to capture a targeted portion of the financial markets. Passive ETFs allow investors to diversify their portfolios while still investing around a particular sector, industry or index. Investors can choose to invest across a multitude of different indexes or benchmarks, from large-cap corporate bonds to small-cap cannabis stocks.

Exchange-Traded Funds (ETFs) vs. Mutual Funds: When Are Mutual Funds Best?

At this point, it may seem clear that exchange-traded funds are the better investment. However, there is a reason mutual funds are still the kings of the hill, with over $54.93 trillion held in funds worldwide. While ETFs focus on cost-reduction and liquidity, mutual funds emphasize providing better overall service quality.

Mutual funds are better choices for investors looking for automatic investment options. Mutual funds allow investors to set up automatic deposits and withdrawals into the fund based on individual preferences. This service is convenient for long-term investment accounts for college or retirement.

Mutual funds are for individuals looking for a more personalized experience in investing. ETFs have lower fees because they do not provide the same customer service as mutual funds. In addition to online and over-the-phone support from industry experts, mutual funds may also offer check-writing options, free fund transfers and other shareholder services.

Finally, mutual funds offer a much wider range of investment options. With 126,500 funds globally, there is virtually an unlimited number of different investment strategies for all asset types available, suiting any individual’s risk tolerance. Mutual funds excel in market areas that experience less trading activity and are considered less efficient. Examples include emerging-markets or high-yield bonds, where active funds have an easier time outperforming passive funds.

Exchange-Traded Funds (ETFs) vs. Mutual Funds: What is the Best Overall Investment?

The big question between ETFs and mutual funds, of course, is which type is better? Both investment vehicles have their pros and cons, and there is no one size fits all answer. However, if we had to choose, despite the service offerings and the wide variety of mutual funds’ choices, ETFs are still generally the better choice.

The low-cost and straightforward fee structure, combined with the tax benefits and ability to trade shares on exchanges and OTC, make ETFs the winner. Although the service offerings mutual funds provide are a nice touch, the cost savings offered by ETFs are simply a much more significant benefit for most retail investors.

Exchange-Traded Funds (ETFs) vs. Mutual Funds: Are ETFs the Best Choice?

Learn more about why ETFs are the better choice here.

Between active ETFs and passive ETFs, passive ETFs are the better choice. Although it may come as a surprise since active ETFs offer continuous professional portfolio monitoring and securities selection, active investment management does not always mean better returns.

While actively managed funds may beat passive ETFs in the short term, it becomes a different story in the long run. The longer the period, the more difficult it becomes for a fund manager to beat the market consistently. Over the past 10 years, from 2010 to 2020, only 24% of all active funds managed to beat the average return rate of passive funds. Combined with higher expense ratios, active funds usually underperform compared to passive funds.

In summary, although the best investment vehicle varies from individual to individual, we view passive ETFs as the best overall investment when assessing exchange-traded funds vs. mutual funds.

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