Mutual Funds vs ETFs

December 21, 2011 / Dominique Brown / Investing / 0 comments

Ever since ETFs or Exchange Traded Funds became popular, the debate about which kind of investment is better has continued to ensue. First of all, mutual funds need no introduction. These have been one of the most highly used investment mediums for any kind of investor because it offers broad diversification, professional management, and low investment minimums. Mutual funds are common in an investor’s portfolio ever since it made its debut in the 1920’s.

However, Exchange Traded Funds are catching up in popularity. Even though it was only introduced in 1993, many investors are beginning to realize the benefits that ETF’s can offer, and it is fast becoming the preferred investment tool for Wall Street and Main Street investors.   The question now is, which investment really is better? Mutual funds or ETF’s?

Mutual funds and ETFs have different legal structures. Mutual funds have two types. First is the open ended funds and second is the closed ended funds. Open ended funds are the most common in terms of volume and assets under management. With this type of fund, the purchase and sale of fund shares take place directly between the fund company and the investors. There is no limit towards how many shares are issued, if more investors choose to buy, then more shares are also offered. Price per share is usually dictated by federal regulations.

Closed end funds issue only a set number of shares and if the investor demand grows, new shares are no longer offered. Price shares are driven by investor demand.   ETFs on the other hand have three structures. The first is the Exchange Traded Unit Investment Trust which attempts to replicate specific indexes and limits investments in a single issue to 25% or less.

Second is the Exchange Traded Grantor which is very similar to a closed-ended fund, but with the difference that investors own underlying shares of the companies that the ETF is invested in. And third is the Exchange Traded Open-End Index Mutual Fund where dividends are reinvested during the day of receipt and only paid to shareholders in cash every quarter. Lending of securities is allowed, and derivatives may be used in the fund.

Trading Process

When it comes to trading, ETFs offer greater flexibility as compared to mutual funds. In mutual funds, purchases and sales are made between the investors and the fund. The price of the fund is determined only at the end of the business day then the net asset value is determined. An ETF is redeemed and created in bigger lots by institutional investors and shares can be traded throughout a day, similar to a stock. ETFs may also be sold short which can be good to traders and speculators. Since ETFs are priced continuously in the market, there is a higher potential for trading and arbitrage because there is more fluctuation in prices.

Shares of mutual funds that are actively traded and actively managed by a fund manager can results in higher management fees. Some ETFs may have lower expense ratios than similar conventional index mutual funds. However, note that most ETFs have expense ratios which are not dramatically lower than the lowest cost conventional index mutual funds with similar investment goals.

Tax Advantages and Disadvantages

ETFs offer better tax advantages to investors since they are passively managed portfolios. This means lesser capital gains than actively managed funds. ETFs are also more tax efficient than mutual funds because of how they are created and redeemed. ETFs only incur capital gains tax when the fund is sold. However, mutual funds will incur capital gains tax as shares within the fund are traded during the life of the investment.

The daily trade volume is usually the measure of liquidity. This is expressed in number of shares traded per day. Securities that are traded thinly are considered to be illiquid and have higher spreads and volatility. The spread increases when there is little interest and low trading volume. The buyer can be caused to pay a price premium and the seller can also be forced into a price discount in order for the security to be sold. When you purchase ETF’s you pay half the bid ask spread. Conventional no-load mutual funds do not have a bid/ask spread involved.

Transferability

Complications can potentially arise when a managed portfolio is transferred to a different investment firm. This can happen with mutual funds because sometimes the fund positions have to be closed out before a transfer can occur. This can be troublesome for investors. Liquidating a portfolio’s mutual fund can increase risk because of trading at the wrong time, increase commission and fees, and incur early and unnecessary capital gains tax. With an ETF on the other hand, transfers can be done cleanly and simply when switching investment firms. ETFs are sometimes called as a portable investment.

Advantages and Disadvantages

When choosing between an ETF and a mutual fund, it is also important to know some advantages and disadvantages of both investment types. ETFS generally offer better tax advantages, liquidity, and low ownership costs. It also has no minimum investment required since investors are limited only by the amount of money you have and the price per share. More options are also available. The drawbacks of ETFs is that they have more transaction costs, brokerage requirement, and dividend drag since dividends paid out by ETFs are not immediately reinvested.

Mutual funds have the advantage of no trading commissions for no-load mutual funds, dividend reinvestment, and no fuss pricing since fund price is ended at each trading day, giving little room for surprises. However, its drawbacks also includes high minimums, additional fees due to front and back end charges, and style drift because funds that aren’t tied to a specific index can be subjected to the whims of portfolio managers.

Ultimately there is no right or wrong answer when choosing between ETFs and mutual funds. However, there are many financial advisors who claim that ETFs hold more advantage than mutual funds. For those who are still choosing between the two investment types, it is essential to understand fully the pros and cons of each type and also to weigh which would be more suitable to your investment needs.

Which investment vehicle do you prefer?