A Comparison of Mutual Funds and Exchange Traded Funds (ETFs): Twelve Factors to Consider

Personal Finance January 06, 2009|Print

Prepared by Dr. Jason L. Johnson, Associate Professor, Extension Economist, Registered Investment Advisor Texas A&M University and Texas AgriLife Extension.

Since the early 1990s, investors have had a choice between traditional mutual funds and a more recent counterpart labeled exchange traded funds (ETFs). Mutual fund assets continue to dominate the financial market with over $12.3 trillion invested. Between 2002 and the end of 2007, assets in ETFs increased almost 500% to more than $608 billion. On the surface, these two investments appear very similar and share a number of common characteristics. Both mutual funds and ETFs are a collection of financial securities that provide exposure to a specified segment of the stock market (or other asset class). In the case of stocks, both mutual funds and ETFs contain a number of individual stocks that provide some diversification from the risks associated with investments in a single company. Furthermore, both investment instruments provide a large degree of liquidity – meaning investors may convert their investments back into cash simply by selling their shares at the prevailing market price. The wide availability of mutual funds and growing availability of ETFs allow investors to easily create a balanced portfolio of investments comprised of any desired mix of stocks, commodities, bonds, real estate, or any other asset.

Mutual funds typically come in two forms: actively managed or passively managed. With an actively managed fund, a mutual fund manager (or team) subjectively selects individual stocks to comprise the fund portfolio. In contrast, passively managed funds rely on some type of defined methodology or formula to guide the fund holdings, with a minimum of management influence. The most common use of passively managed mutual funds involves those designed to track the performance of numerous individual market indexes (i.e. index funds). In general, an ETF operates similarly to passively managed mutual funds, but are traded in the open market.

Exchange traded funds (ETFs) can be either actively or passively managed funds, but they are listed on an exchange and trade like a share of stock. ETFs can track an index, commodity, or a basket of assets like an index or mutual fund. ETFs experience price changes throughout the day as they are bought and sold. Unlike mutual funds that have their Net Asset Value (NAV) calculated at the end of each day, ETF prices are set by the buying and selling prices that occur in the open market. Ownership of an ETF provides diversification similar to an index fund, however the expense ratios for most ETFs are lower than those of the average mutual fund. When buying and selling ETFs, you have to pay the same commission to your broker that you'd pay on any regular order to purchase or sell stocks. One of the most widely known ETFs is called the Spider (SPDR), which tracks the S&P 500 index and trades under the symbol SPY.

Investors should understand that there are enough differences between mutual funds and ETFs to warrant careful consideration. This learning lesson is intended to assist investors in identifying which type of investment (mutual fund or ETF) is most appropriate to utilize in their investment accounts. The following discussion identifies twelve specific comparison factors between mutual funds and ETFs. In the end, it is up to the individual investor to weigh the considerations that are most important or most relevant to their unique circumstances.

Lower Expense Ratios – Advantage: ETFs

An expense ratio is the annual expense (expressed as a percentage of invested assets) that a money management firm retains to pay for management expenses. For example, an expense ratio of 1% means that $10 of every $1,000 invested goes toward fund expenses. One major advantage of ETFs is their very low cost of operation, frequently half the annual expense of a passively managed index mutual fund, and considerably less than an actively managed mutual fund.

Mutual funds generally cost more than ETFs because they must pay fund managers, issue monthly statements, provide other customer services, and often provide compensation to a salesman. In addition, some mutual funds charge 12(b)-1 fees for fund marketing expenses. The composition of investments within an ETF are typically managed by a defined formula and managed electronically. Since ETFs are generally passive investments, there are no professional manager salaries or research analyst staff expenses incurred. Services that mutual fund management companies typically provide are instead provided by the brokerage firm or the investor’s financial advisor. By avoiding those tasks, ETFs avoid the expenses that go with them. However ETF investors will need to pay brokerage commissions, as described further below.

The average annual expense ratio for retail mutual funds is 1.56% versus 0.40% for ETFs. ETFs are even cheaper than the average index mutual funds, which cost an average of 1.06%. If a comparison is made between an ETF and any mutual fund that charges front or back end load fees, then this comparison favors ETFs even more strongly. Consider that a mutual fund with a 5% load (not uncommon) represents a charge to investors that is more than 12 times the annual expense ratio of the typical ETF.

Improved Tax Efficiency and Management – Advantage: ETFs

ETFs enjoy great tax efficiency as a result of extremely low portfolio turnover and low capital gains distributions. Turnover is the purchase and sale of securities in a fund's portfolio. Low turnover tends to indicate a longer-term investment orientation, while high turnover indicates a shorter-term focus. Turnover has a significant influence on two aspects of investment performance: the cost of management and the realization of capital gains (triggered when a security is sold). The higher the portfolio turnover, the higher the fund's transaction costs, and higher the proportion of total return is comprised of taxable capital gains. High turnover and higher capital gains distribution both result in reducing returns to investors.

Actively managed mutual funds usually engage in high turnover, which generates capital gains distributions – forcing investors to pay taxes. Index mutual funds themselves are highly tax efficient compared to actively managed mutual funds, but still make capital gains distributions. Because ETFs tend to maintain more stability in their stock positions for longer periods of time, their turnover is relatively low. In addition, ETFs have the ability to remove their lowest cost-basis shares from the fund portfolio by exchanging them with institutional arbitrageurs (called in-kind redemptions). This enables ETFs to avoid realizing capital gains when the ETFs have to modify the composition of the fund to track changes in their benchmarks.

ETFs also enable investors to better manage the taxable implications that result from owning them. If ETFs are purchased in a brokerage account and purchase price details are recorded, investors can ensure that when the time comes to sell, they are able to identify and sell the ETF shares that have the highest cost-basis, thereby minimizing taxable capital gains. In contrast, mutual fund holdings are often reported and sold using the average purchase price as the cost basis. The use of dividend reinvestment of mutual fund shares makes it time consuming and even more difficult to identify the cost basis of individual shares. This reduces the investor’s ability to manage mutual fund share sales in a tax advantaged manner.

Timely Reporting of Holdings – Advantage: ETFs

ETF holdings are generally updated daily, so it’s easy to find out exactly what components are included in the market basket represented by the ETF investment. That makes ETFs more transparent and easier to analyze than mutual funds when an investor examines their investment exposure to specific sectors of the economy or geographic regions.

Alternatively, retail mutual funds are required to reveal their holdings only twice per year (although some mutual funds choose to disclose holdings more often). This less frequent filing of holdings poses two potential concerns. First, the holdings of a mutual fund investment might be substantially different from what the investor thought they were purchasing based on the last reported disclosure. Second, infrequent reporting creates an incentive for the mutual fund manager to engage in “window dressing.” This is the manipulation of investments in a fund that includes selling poor performing stocks that were held throughout the period and buying larger positions of better performing stocks (that were not held throughout the period) just prior to reporting the fund’s holdings. These after-the-fact manipulations falsely represents the actual holdings within the mutual fund between reporting periods and make it difficult to evaluate whether the fund manager was able to anticipate positive developments before those benefits were reflected in the prices of stocks held by the fund.

Increased Price Certainty – Advantage: ETFs

ETFs are priced in real time throughout the day, just like shares of individual stocks. ETFs are traded openly on exchanges, where the bid-offer spread is publicly available and reflects current market sentiment. Purchase or sell orders for ETFs are executed immediately if they are submitted when the stock market is open and actively trading.

In contrast, mutual funds are priced only once per day, after the market has closed. When buying or selling mutual funds, investors are unaware of the executed share price until after the market closes. Also, it is not uncommon for submitted orders to purchase or sell mutual fund shares to take one to two business days to be executed by the mutual fund company and recognized in the account.

Less Potential for “Style Drift” – Advantage: ETFs

Some studies indicate passive management beats active management by 1-3% per year, and that kind of difference tends to add up fast over time. ETFs can be selected which mimic broad market indexes, or highly specialized ETFs which track the performance of stocks in a specific economic sector or region of the global economy. Either way, ETFs rely on a well-defined methodology that refrains from trying to time the market or subjectively pick individual stocks. This creates the ability for investors to track specific segments of the market, without the influence of individual fund managers.

A mutual fund portfolio manager attempts to use experience and analytical tools to identify the best investments and avoid poor ones. Mutual funds tend to hold securities that are individually selected by the fund’s manager. These holdings change constantly, and the instability of the fund’s holdings can lead to periods of good and bad performance streaks that do not necessarily reflect the performance of the underlying asset class.

One common occurrence resulting from active management is called “style drift.” Style drift is the term used to describe a mutual fund drifting away from a specific investment objective, style, or asset class that is expressly stated as the investment purpose of the fund. Since ETF investments are defined and managed passively, there is no room for interpretation as to which investments are appropriate. Thus, style drift is less frequent than with mutual funds and the ETF performances are more likely to properly reflect (for better or worse) the performance of the defined investment area it is designed to mimic.

Lower Minimum Initial Investment – Advantage: ETFs

Many mutual funds have required minimum initial investments. These minimum initial investment levels are sometimes lowered if the investor is establishing an Individual Retirement Account, Educational Savings Account, or participating in an automatic investment program (where investors agree to electronically deposit a specified amount into their account until the account satisfies the minimum requirements). In any case, it is not uncommon for the minimum initial investment to establish an account with a mutual fund company to be $2,500 or more, with some fund companies having minimum initial investment levels exceeding $50,000. This makes these investments unavailable to many investors.

In contrast, there is no minimum initial investment level associated with investing in an ETF. As long as the investor has enough money in their brokerage account to pay for one share of the desired investment, plus the associated brokerage commission, they are allowed to invest. Of course, it would always be preferable to build investable cash to a level where the brokerage commission did not represent a significant percentage of the overall expenditure before making any investment. For example, a $10 brokerage commission applied to investments of $500, $1,000, and $2,500 represents a commission expense of 2%, 1% and 0.4%, respectively. Therefore, the brokerage commission accounts for a smaller percentage of the investment as larger amounts are invested in a single transaction.

Ability to Monitor Asset Allocation – Advantage: ETFs

Asset allocation can more easily be monitored with ETFs. Investors can own mutual fund shares in a brokerage account, but only mutual fund company sponsored ETFs in a mutual fund account. Since all ETFs are traded on one of the three major U.S. exchanges, they can be held in a single brokerage account. A brokerage account consisting of a basket of ETFs (representing stocks, bonds, real estate, commodities, etc.) enables investors to keep all assets in one place. This means that a complete picture of an investor’s asset allocation can be easily monitored and managed.

In order to match this level of convenience through ownership of mutual fund shares, investors would likely be constrained to only products offered by one (or partnering) fund family choices. Monitoring alternative investments often involves jumping from one mutual fund account to another. While mutual fund “supermarkets” (i.e. the availability of many different fund families through a single brokerage) do exist, all fund families do not participate including many of the low-cost, no-load mutual fund families that are very popular. There also tends to be additional restrictions (i.e. specified holding periods without incurring additional fees), when mutual fund shares from alternative mutual fund companies are purchased through a mutual fund supermarket account.

Lower “Cash Drag” – Advantage: ETFs

“Cash Drag” can be defined as a reduction in investment performance as a result of maintaining a portion of investable funds in the form of cash. Conventional mutual funds typically need to maintain a small amount of their portfolio in cash in order to meet ongoing cash redemptions as some investors request to liquidate their holdings. In order to facilitate these requests, mutual fund managers will carry some level of cash to avoid having to liquidate stock positions to fulfill these requests. It is not uncommon for an equity mutual fund to maintain 2 to 10% of its assets in the form of cash. An ETF has no such need because it never has to deal with investor redemptions. When an ETF investor wants to liquidate their holdings, they simply sell their shares to another investor in the open market through their brokerage account. While the overall performance impact of holding a portion of the investment in the form of cash could be either positive (in a declining market) or negative (in an increasing market), investors seldom choose to pay commissions and management fees to track the performance of cash. This reduced “cash drag” may provide a slight advantage for ETFs over mutual funds in attempting to better match the performance of the index or asset that they are designed to reflect.

Increased Price Efficiency – Advantage: Mutual Funds

There are two price efficiency issues that favor mutual funds. The first of these is the “bid-ask spread,” which is characteristic of any open market transaction. When investors buy or sell ETFs, there is a hidden fee in the form of the "bid-ask spread." The bid price is the price at which a hopeful buyer of the ETF is willing to pay. The ask price is the price at which a current owner of the ETF is willing to sell. The nature of open markets means that buyers purchase at the higher of these two prices and sellers sell at the lower of these two prices. Typically, the higher the average daily volume of shares traded, the lower will be the bid-ask spread. ETFs that have lower average daily volumes of shares traded sometimes have large bid-ask spreads making it costly to buy or sell the ETF. Mutual fund purchases and sales do not involve a bid-ask spread since the price of shares is always determined only once per day after the market closes.

The second price efficiency issue that can favor mutual funds involves the absence of any premium or discount associated with mutual fund share prices. A mutual fund's share price is always reflected by the fund's net asset value (NAV). The NAV is the weighted-average current market value of all the fund's holdings, expressed on a per-share basis. An ETF, on the other hand, is valued by the market. So its market price at any particular time can be either above the NAV (meaning it is selling for a premium to the per-share value of the ETFs holdings) or below the NAV (meaning that it is selling at a discount). While there is always a financial incentive to drive prices back towards the NAV, premiums and discounts can persist (at some level) for prolonged periods of time.

Lower Trading Expenses / Facilitates “Dollar Cost Averaging” – Advantage: Mutual Funds

Purchasing or selling ETFs incurs a brokerage commission. Higher trading commissions can offset the lower fees associated with ETFs if investors overtrade or frequently buy small amounts. Trading commissions can quickly add up, even with the use of an online discount broker with fees amounting to about $10 per trade. No such fees are typically needed to buy or sell no-load mutual fund shares in an account held directly with the mutual fund company.

Trading commissions make ETFs undesirable vehicles for dollar cost averaging or other approaches that involve investing small amounts at frequent intervals. If an investor purchased $100 worth of an ETF every month (paying $10 commission each time), at the end of the year they would have purchased $1,080 worth of shares and paid $120 in trading commissions. Alternatively, if an investor purchased $100 worth of a no-load, no-transaction fee mutual fund directly in their mutual fund account, at the end of the year they would have purchased $1,200 worth of shares – 11% more than with an ETF.

Strategies such as dollar-cost averaging prove to be much more effective with investments like no-load mutual funds where there are no additional costs for individual transactions. ETFs are more practical for investing larger amounts of capital (relative to the commission paid to the broker).

Availability of Investment Alternatives – Advantage: Mutual Funds

Even though the number of ETFs has grown significantly in recent years, there is a much wider selection of mutual funds from which to choose. In fact, there are more mutual funds available than there are individual stocks listed in the United States. The number of mutual funds available to investors at the end of 2007 exceeded 8,000. Available ETFs at the end of 2007 totaled a little more than 600 (Investment Company Institute). In some investable areas, like international stocks, the number of ETF offerings does not match the array of style, size, and regional combinations that can be obtained with mutual funds. As ETFs grow in popularity and familiarity, the breadth of investing opportunities will undoubtedly expand. At the present time, however, mutual funds still provide a broader investment selection.

Facilitates Dividend Reinvestment / Lower “Dividend Drag” – Advantage: Mutual Funds

Many people choose to have distributions of conventional mutual funds automatically reinvested in additional shares of the fund. Aside from the convenience, this automatic pilot approach keeps money working for investors without requiring extra effort to redeploy dividends or capital gains distributions.

The availability and cost of automatically reinvesting dividends of ETFs depends upon the broker, but is typically not available. Many discount brokerages do not allow for ownership of fractional shares, which would be a likely result of dividend reinvestments. More commonly, ETF dividends are paid out at the end of each quarter and credited to the balance of the brokerage account in the form of cash. If an investor wants to then reinvest that cash, they need to place a buy order to do so (and incur whatever transaction costs apply). This has a slightly adverse effect on performance and is called "dividend drag,” which describes the accumulation of cash instead of additional shares.

The table below lists the advantages held, respectively, by exchange traded funds and mutual funds:

Table 1 Mutual Funds Versus ETFs: Summary of Factors to Consider

Issues for Consideration Advantage
Lower Expense Ratios
Exchange Traded Funds
Improved Tax Efficiency and Management
Exchange Traded Funds
Timely Reporting of Holdings
Exchange Traded Funds
Increased Price Certainty
Exchange Traded Funds
Less Potential for "Style Drift"
Exchange Traded Funds
Lower Minimum Initial Investment
Exchange Traded Funds
Ability to Monitor Asset Allocation
Exchange Traded Funds
Lower "Cash Drag"
Exchange Traded Funds
Increased Price Efficiency
Mutual Funds
Lower Trading Expenses/Facilitates "Dollar Cost Averaging"
MutualFunds
Availability of Investment Alternatives
Mutual Funds
Facilitates Dividend Reinvestment/Lower "Dividend Drag"
Mutual Funds

Summary

The overall goal of an investment program is to build a diversified portfolio containing multiple asset classes (domestic stocks, foreign stocks, bonds, real estate, commodities, etc.) with the lowest possible fees and the greatest possible tax efficiency. Individual circumstances and preferences will determine whether gaps in asset allocation are best filled using ETFs or mutual funds. The frequency of investments (lump sum, periodically, or regularly) is one factor that will strongly influence which investment type (ETF or mutual fund) is most appropriate. But that factor alone should not entice investors to only adopt one investment type. With a little due diligence (examining what holdings are represented within the ETF or mutual fund) and an understanding of the expense ratios, trading costs, and future trading plans, an effective and well-considered investment plan can be implemented.

This learning lesson described twelve factors to consider in the decision making process regarding which investment type, exchange traded funds or mutual funds, is most appropriate. The importance and weight given to any one issue will vary from one investor to another. There are no rules preventing investors from utilizing a mix of ETFs and mutual funds to build their investment portfolio. In fact, for most investors, this is probably the optimal strategy to accommodate the different investment plans and accounts that they possess. The exciting aspect of this discussion involves the wide array of investment opportunities available to address investor needs.

ETFs and mutual funds allow for investors to gain instant financial exposure to any asset class they choose to complete the diversification process. It is hoped that this description of the trade-offs between ETFs and mutual funds will make the decision process easier and more successful for investors. Table 2, below, presents a comparison that describes the motivations that might guide an educated investor’s choice between investing in a mutual fund or investing in an ETF.

Table 2 Suitability of Investment Alternatives for Different Investors

Investors in Mutual Funds Investors in ETFs
Want to purchase a collection of securities at their net asset value.
Prefer to have a “real-time” price in which to execute purchase and sell decisions.
Prefer the advantage of lower acquisition costs (of no-load funds) over the higher expenses for on-going management.
Prefer the advantage of lower expenses for on-going management over the higher acquisition costs (brokerage commissions).
Have enough investment funds to meet the minimum initial requirements for opening an account.
Have the discipline required to refrain from over-trading and racking up excessive trading commissions.
Comfortable allowing professional money managers select stocks and manage the portfolio of investments for them.
Want to track the performance of a market index or sector as closely as possible, without the subjective interference of a money manager.
Plan to invest using a “dollar cost averaging” approach; small amounts of money invested frequently over time.
Prefer the improved tax efficiency and individual control of the taxable ramifications associated with selling securities.
Prefer to have dividends reinvested automatically.
Want to be able to review their holdings within the investment to help evaluate their current asset allocation.

References

Bogle, J. C. (1994). Bogle on mutual funds: New perspectives for the intelligent investor. New York, NY: Bantam Dell Publishing Group.

Edelman, R. (2007). The Lies About Money. New York, NY: Free Press.

Investment Company Institute. (2008). 2008 Investment company factbook: Review of trends and activity in the investment company industry. Washington D.C.: Investment Company Institute.