How do Mutual Funds and ETFs differ?
A basic and important concept for investors is the diversification of investment assets. This principle is represented by the old saying “never have all your eggs in one basket”. And more recently, for those investors who focus on so-called ‘concentrated’ portfolios, if you have them ‘all in one basket, you need to keep a very close eye on the basket!”.
Certainly, under normal market conditions, having a diverse selection of investments should help reduce the risk of all the assets moving in the same direction at the same time when the market stumbles (and it always stumbles!). Under normal market conditions, a well-diversified investment portfolio will can help hedge some of the market risk, and should improve the overall investment portfolio performance over time.
The mutual fund industry, as we know it today, evolved as a product marketed to a broad range of investors allowing those without the time, expertise, and large amounts of capital required, to gain exposure to a highly diversified stock portfolio. A mutual fund uses pooled investor capital in the fund to purchase investments which have been selected by the fund’s professional investment managers. These investments meet certain criteria, and are chosen as the optimum stocks and weightings to attain the investment goals specified in the fund prospectus.
It is commonly said that it requires at least 10 or more different stocks to really capture the benefits of diversification. For a small or simply less well-off investor trying to achieve diversification without a mutual fund, the time and cost required of trying to replicate a diversified fund can become prohibitive.
The mutual fund product has now been established for well over half a century. But, about a decade ago, the asset management industry developed a new product to capitalize on the perceived weaknesses of the mutual fund model. The new “evolution” of the mutual fund is called the Exchange Traded Fund (ETF). ETFs do indeed have some important advantages which are not found in the traditional Mutual Fund model.
What is an ETF?
An ETF shares some similarities with a mutual fund. The fund holds investments based on specific asset categories and themes, from which investors can choose. However, with a mutual fund, the shares are selected by the portfolio manager. With an ETF, the shares are linked to the underlying benchmark, which can range from a stock index such as the S&P, to a stock sector index, a bond index, a leveraged index, or a commodity index. The statistics suggest that the majority of mutual funds underperform during up markets, whereas an ETF will track the markets. The reverse is true during down markets. Presumably, this is because mutual funds can switch stocks to a more defensive portfolio orientation, or even hold cash. This does not happen with an ETF, and in bear markets ETFs will be fully exposed to the underlying asset category – for better or worse!
A major plus for ETFs over mutual funds is the fact that the ETF fund unit value is calculated on a real time basis and the shares of ETFs can be bought and sold anytime during market hours, just like individual stocks. Mutual funds, on the other hand, are priced after the close of the market day.
ETFs also provide a very cost effective way to hold a basket of stocks representing a market index. ETFs allow investors to ‘purchase’ a market index with minimum or no management fees, although obviously commission must be paid, and sometimes other ‘expenses’ related to the fund (see note on expense ratios at the end of this article). They can be particularly useful for gaining exposure to some of the less liquid areas of markets, for example smaller stock indices.
Nowadays, there is a lot of choice when it comes to ETFs, and just about any major investment strategy can be replicated. As of 2015, there were over 4,000 different ETFs being traded, and over 8,000 mutual funds.
In summary, both ETFs and mutual funds can provide a good long term investment vehicle for most retail investors, as well as pension funds. ETFs can also be used for more aggressive sector trading as they function very much like stocks. However, it is important to look carefully at the total fees and charges, as well as past returns associated with both types of funds. Over the long term, these can make a significant difference in total return.
Note on expense ratio: All ETFs and mutual funds charge certain fees. These fees can be compared by locating the expense ratio for the fund, which is usually found in the fund prospectus if it cannot be located on line. This ratio is usually expressed as a percent of assets under management (AUM). In most regulated markets, funds are required to send all investors a prospectus about the fund along with the expense ratio. Quite a few funds may quote their historical performance without deducting fund expenses. All fund fees must be deducted from fund returns to calculate actual total realized returns. Fund expense ratios can be as low as 0.05%, and up to as high as 3%.