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EXCHANGE-TRADED FUNDS | MODULE 2

COMPARING ETFs AND MUTUAL FUNDS

Continue the ETFs course with module 2, which compares the benefits of investing in ETFs and mutual funds and outlines key concepts to consider before investing.

HOW ETFs AND MUTUAL FUNDS ARE USED
Financial professionals use ETFs and mutual funds to pool investors’ money together and invest it across stocks, commodities, bonds, or other assets. ETFs and mutual funds are commonly used among investors.
How ETFs and mutual funds are used

CHOOSING THE RIGHT
INVESTMENT VEHICLE

The pros and cons of ETFs, mutual funds and stocks

Below is a breakdown of the advantages and drawbacks of ETFs and mutual funds, and how they compare to individual stocks. Financial professionals should consider mapping their clients’ needs against the benefits of each investment vehicle to determine the best approach when building a portfolio.

 

Active mutual fundsiShares ETFsStocks
Diversified

Many stocks or bonds in a single fund

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Traded on exchange throughout trading day

Buy and sell whenever the market is open

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Intraday pricing

Live pricing throughout the course of the trading day

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Management fees

Annual cost of a professionally managed fund

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Transaction fees

Costs associated with buying or selling (e.g., mutual fund sales loads, brokerage commission fees)

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Tax efficient1

Generally have fewer unplanned capital gains distributions

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Index tracking

Seek to track the return of a market index

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1 Due to fund structure, mutual fund holders may be subject to taxable capital gains distributions due to other investors' redemptions directly to the mutual fund. Taxable capital gain distributions can occur to ETF investors based on stocks trading within the fund as the ETF creates and redeems shares and rebalances its holdings. ETFs and stocks will also distribute taxable capital gains when an investor sells their own shares. Certain traditional mutual funds can also be tax efficient.

THINGS TO CONSIDER
BEFORE INVESTING

1) Compare investment strategies

Investments can either be managed actively, like most mutual funds, or can be indexed, like most ETFs. Active funds seek to outperform market indexes whereas index funds are measured by their ability to match their performance to an established index, like the S&P 500.

Fund managers study the market and draw on their investment experience and expertise to try to maximize the fund’s performance but in turn, could result in higher fees than an index fund.

2) Consider the impact of fees

There are two main costs to consider with investments: Transaction fees and the fund’s expense ratio.

Transaction fees are paid directly by investors
For mutual funds
Transaction fees may include sales loads (also called sales charges) or redemption fees.
For ETF transactions
The fees occur when an ETF is sold or bought through a broker as a commission, similar to stock trades.
Fund’s expense ratio
Expense ratio
This is the operating cost divided by the average dollar value under management as of the investment’s fiscal year end. This is reported in the fund’s prospectus.
The management fee
These are fees paid to the fund manager and are one of many operating costs make up the expense ratio. This is usually the largest and most variable part of the cost.

Other fees that make up operating costs can include custodial services, recordkeeping, legal expenses, acquired fund fees and expenses (if the fund invests in other funds), accounting and auditing fees, or a marketing fee (called a 12b-1 fee). Operating expenses are taken directly out of the fund resulting in a lower return to the investors. In general, funds that pursue an active investment strategy will have higher operating costs than indexed funds because they are seeking excess return than the index.

3) Remember to evaluate taxes

Most ETFs incur fewer capital gains given that they are indexed investments and typically trade less frequently than most active mutual funds.

When mutual fund investors redeem shares from the fund, the fund manager will often sell fund securities to honor these redemptions. This process triggers capital gain distributions for other investors who make up the pooled investment. Because investors can buy and sell ETFs on an exchange, the ETF manager does not have to sell holdings to meet investor redemptions, which limits the capital gains created.

Certain traditional mutual funds can be tax efficient and, of course, ETF investors can incur tax consequences when they sell shares on the exchange, but that tax consequence is not passed on to other ETF investors.

THINK DIFFERENTLY

Compared to mutual funds, ETFs are simpler, more cost-effective and can generally be lower risk. They offer immediate visibility and flexibility in trading at any time during trading hours. If an investor currently holds mutual funds in their portfolio, ETFs can be a great addition as they can offer potentially more predictable return.

 

This concludes the second module of the ETF course. Read the next module, which determines what to consider when investing in ETFs, to continue the course.

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Financial professional
I professionally manage portfolios on behalf of individual investors and provide financial advisory services. Examples of financial professionals include financial advisors, private bankers, etc.

Institutional investor
I professionally manage portfolios on behalf of institutions such as pension funds, sovereign funds, insurance companies, etc.

Individual investor
I buy and sell securities for my personal account, not for another company or organization. I am not a financial professional nor an institutional investor.