A term “mutual fund” has become so familiar that it is hard to imagine one’s investment portfolio without at least a single mutual fund in it. In short, a mutual fund is a form of collective investing where investors pool money into an investment fund managed by a fund manager. The fund manager then purchases securities in accordance with investment mandate and sells the fund shares to the general public.
More than 20 years ago another form of collective investing was developed and introduced and is known as exchange-traded funds (ETFs). For a long time, ETFs were mostly ignored by investors and the investment community until now. Today, many investors face a dilemma whether to purchase a mutual fund or an ETF. Before I explain the key difference, let’s start with a quick breakdown.
Presently, there are 7,923 mutual funds with total assets under management of $15.8 trillion. On the other side, there are only 1,411 ETFs with combined assets under management of $1.9 trillion.
Clearly, mutual funds remain the dominant investment vehicle among investors. ETFs have total assets of about $2 trillion, which is peanuts when compared to almost $16 trillion for mutual funds. The same for a total number of funds. There are only 1,411 ETFs vs. 7,923 mutual funds.
One might quickly draw a conclusion that investing in mutual funds is better than in ETFs, otherwise there wouldn’t be so many funds and investors wouldn’t entrusted so many assets. Let me show you one more chart.
If we look at the chart above, it is obvious that ETFs assets grow at a faster rate, 46.2% per year (since they were introduced) vs. 9.7% for mutual funds. Moreover, Goldman Sachs forecasts that ETFs total AUM will top $6 trillion by 2020.
Enough introductory. Let’s finally find out why more and more investors prefer ETFs.
Key Advantages of ETFs Over Mutual Funds
- Lower Costs. Mutual funds levy a lot of fees and expenses on investors, such as management, service, and load fees for sale and distributions. ETFs, in turn, do not charge load fees and 12b-1 fees. Plus, they are usually passively managed, which makes them cheaper. For instance, Vanguard Total Stock Market Index Fund Investors Shares (VTSMX) has an expense ratio of 0.17% versus 0.05% for the same ETF (VTI). As I’ve shown previously, high fees negatively effect your overall performance.
- More Flexibility. ETFs trade on a stock exchange and in the same manner as stocks. That means investors can buy and sell them during market hours within seconds as well as buy them on margin and sell short. In addition, there are options on many ETFs which allow investors to utilize different strategies to hedge their positions.
- Full Transparency. As I mentioned above, ETFs trade on a stock exchange just like stocks do, which means you can check the price of your ETF at any time. Unlike ETFs, mutual funds calculate their share price at the end of the day based on the net asset value. Besides that, ETFs usually public their positions on a daily basis, while mutual funds are required to do so only once in a quarter.
- Tax Efficiency. When a mutual fund investor needs his money back, the mutual fund manager has to sell the shares on the market in order to meet this redemption. Each such redemption as well as re-balancing actions by the fund manager trigger tax consequences due to passing profit on to other shareholders at the end of the year. Skipping details, ETFs are structured differently and when an investor needs to sell shares s/he does so through an authorized participant, by-passing the fund. In addition, most ETFs are usually index funds, which means they have a low turnover and rarely realize profit on their holdings. Please note, that when an ETF holder does eventually sell the ETF on the market for a profit, s/he will have to pay capital gains tax (like with a stock).
- Accessibility. ETFs do not have a minimum investment requirement, which means you can start investing with as low as $15 or so. On the contrary, most mutual funds usually set a minimum investment threshold of $3,000 and up to $10,000, which makes it inaccessible for young investors.
Regardless of current mutual funds reign, ETFs continue to grow its market share at a much higher rate and currently there are no obvious reasons why the trend should reverse. Despite a lot of similarities, ETFs possess key characteristics that make them invaluable and preferred investment vehicles. If your investment portfolio currently composed of mutual funds, then I encourage you to shake it up and see if you can make any adjustments by substituting them with a cheaper and tax-efficient ETFs.