The Differences Between ETFs vs. Mutual Funds

ETF’s and mutual funds are another of those investment terms that seem interchangeable. And while they frequently come up in the same discussion, they’re actually very distinct investments. Both are funds made up of dozens or hundreds of different securities.

But how they’re managed, and how they’re used in an investment portfolio can seriously vary.

Let’s investigate the differences between the ETFs vs. mutual funds.

Exchange Traded Funds (ETFs)

What is an ETF?

An ETF is a basket of securities held in a fund that tracks an underlying index. The mix of securities held in the fund is not arbitrary. The fund is configured to reflect the makeup of the underlying index.

For example, the most common index for ETFs is the S&P 500 index.

An ETF is tied to this index and will have proportional interests in all 500 or so stocks that make up that index.

The fund is designed to track the movements of the S&P 500. The investor is virtually buying the performance of the S&P 500 with this type of ETF.

Unlike mutual funds, ETFs trade just like stocks. They even trade on the various stock exchanges. You purchase shares of an ETF just as you would the stock of an individual company. For this reason, brokerage firms typically charge the same commission for the purchase of ETFs as they do for stocks.

For example, a broker might have a commission to both buy and sell at a commission of $7 for stocks and ETF’s.

When you own shares in an ETF, you don’t own the securities held in the fund. Those are owned by the ETF itself. Investor ownership of those securities is only indirect.

Shareholders are entitled to receive a portion of any interest or dividends paid by the underlying securities. They’re also entitled to receive a proportional residual value if the fund is ever liquidated.

Since they trade like stocks and on stock exchanges, ETFs tend to be more liquid than mutual funds. They can be bought and sold just as stocks are, without having to go through various fund families, and their individual redemption policies.

“Passive” Management

Since ETFs are index-based, they’re considered to have passive management. Unlike mutual funds, where the fund manager will buy and sell securities as deemed necessary, ETF’s only trade securities when the composition of the underlying index changes.

Since that doesn’t happen very often, there’s very little buying and selling within the fund. For example, if ABC Company is dropped from index, and replaced by XYZ Corporation, only then will the ETF execute trades. They’ll do it to maintain the configuration of the index.

This leaves very little trading during the course of a typical year. In effect, the fund creates a portfolio to match the underlying index, and makes changes only when the index does.

For this reason, ETFs generate little in the way of capital gains. And when they do, it’s incidental.

For example, if the fund drops ABC Company from its portfolio at a higher price than it was purchased at, the fund will generate either a capital gain or capital loss. But that’s a fairly rare event.

Since they’re tied to an underlying index, the value of each share in an ETF rises and falls with that index. This is another way ETFs function like stocks. Gains and losses with an ETF are reflected in the price of the fund. Like a stock, you can hold an ETF until it doubles or triples in value, and then sell it to realize your gain.

Tax Implications of Passive Management

There are big advantages to the passive management of ETF’s. Actively managed funds – which many mutual funds are – tend to generate capital gains. Long-term capital gains have more favorable rates, and were capped at 0%, 15% and 20% for 2018. (Most taxpayers will fall into the 0% rate.)

Short-term capital gains however are subject to ordinary income tax rates. Those can be as high as 37%. A short-term capital gain is any gain realized on a stock or security that was purchased no more than one year earlier.

Actively managed funds often generate short-term capital gains, as well as long-term capital gains.

This is why mutual funds often report both long-term and short-term capital gains, as well as dividends at tax time. With ETF’s, dividends are generally the primary taxable income.

There may be a small amount of long-term capital gains, related to changes in the underlying index. But short-term capital gains are unlikely, since ETF’s don’t actively trade.

This means ETF’s work largely on tax deferral. Instead of the individual securities within the fund generating capital gains, the ETF itself does. But those gains aren’t recognized until you sell your position in ETF. Only then will you have a capital gain, and it will almost certainly be long-term. That will make it eligible for the lower long-term capital gains tax rates.

In that way, if you hold an ETF for 20 or 30 years, you won’t have any substantial capital gains until you sell the fund. That will go for the payment of taxes well into the future. This is much like a tax-sheltered retirement plan, except it applies even in a taxable account.

ETF Fees

ETF’s charge what are known as 12b-1 fees. These fees have two parts:

1.  Distribution fees. These are fees paid for marketing and selling fund shares. It includes compensating brokers and others who sell fund shares, plus advertising, printing and mailing of prospectuses to new investors, and printing and distributing sales literature. This portion of the fee is limited to 0.75% of the fund balance each year.
2. Shareholder service fees. These are fees paid to people who respond to investor inquiries, and provide investors with investment information. This portion of the fee is limited to 0.25% of the fund balance each year.

The total of the two parts of the 12b-1 fee is 1.00%, which is legally the highest amount that can charge. But many ETF’s have much lower 12b-1 fees.

And it matters:

Let’s say you have a choice between two ETF’s, both based on the S&P 500 index. One has 12b-1 fees of 1.00%, in the other 0.50%. That’s the difference of 0.50%. It’s also the amount that will reduce the net return on investment from each fund.

Both funds are expected to produce a nominal return of 10% per year. But when you deduct 12b-1 fees, the first fund has a net return of 9%, and the second 9.5%.

If you invest $10,000 in the first fund for 30 years, at the net annual return of 9%, your account will grow to $132,684. If you invest $10,000 in the second fund for 30 years, at a net annual return of 9.5%, your account will grow to $152,200.

half percent per year may not seem like much, but over 30 years it’s worth nearly $20,000. Moral of the story: 12b-1 fees matter. Look for ETFs with the lowest fees.

Broker Commissions

These fees are not charged by ETFs themselves, but by the investment brokerages who sell them.  It’s usually the same fee that’s charged for buying and selling individual stocks.

The most popular brokerage firms charge between $5 and $10 per trade, regardless of the dollar amount of the fund purchased.

Unless you plan to actively trade ETF’s, broker commissions will be only a minor expense.

The Benefits of ETFs

ETFs have certain definite advantages:

Low tax liability. Since they generate little in the way of long-term capital gains, and typically no short-term capital gains, tax consequences are low from one year to the next. Even the dividends paid are frequently qualified dividends that are taxed at long-term capital gains rates. For most taxpayers, that will be no tax due on the dividends.

Tracking the markets. If your primary reason for investing in funds is to match the performance of the market, ETFs are the perfect vehicle. They won’t outperform the market, but they won’t underperform it either. That makes them a perfect asset allocation in a balanced portfolio.

What’s more, since they track so many indices, you can find an ETF for just about any investment segment.

This includes large-cap stocks, mid-cap stocks, small-cap stocks, foreign stocks, emerging market stocks, and various industry segments, like healthcare, high-tech and housing.

ETFs are also available for non-stock assets, like bonds, government securities, gold and other commodities, and real estate.

Low fees. Since they don’t charge load fees, they can be bought and sold without concern for transaction fees – other than broker commissions.

And 12b-1 fees, while annual and admittedly annoying, can be extremely low on certain funds. There are a large number of ETF’s where the fees are below 0.20%. Those are the ones you should favor.

How and Where to Invest in ETFs

When you buy an ETF, it’s similar to buying a stock. You can purchase an ETF either by shares or by a flat dollar amount. The funds typically don’t have investment minimums, which makes them particularly attractive for new and small investors.

You can invest in ETFs through large investment brokerage firms like Ally Invest, E*TRADE or TD Ameritrade. Each offers a wide variety of ETF’s, and has reasonable trading commissions.

But there’s another way you can hold ETFs, if only indirectly.

Robo-advisors typically hold mostly ETF’s in the portfolios they create for you.

Since the Modern Portfolio Theory they invest by is dominated by asset allocation, ETF’s are the perfect way to achieve the diversification they want.

A typical robo-advisor will construct your portfolio from between six and 12 different ETF’s. Each will represent a specific asset class. This usually includes foreign and domestic stocks, emerging market stocks, domestic and international bonds, and sometimes commodities and/or real estate.

Some of the more popular robo-advisors include Betterment, Wealthfront and Ally Invest. They’re perfect platforms to invest in ETFs through, especially if you don’t know which funds you want to hold.

Mutual Funds

What is a Mutual Fund?

Much like an ETF, a mutual fund is a basket of securities held in one fund. But how it works in practice is much different from an ETF.

Mutual funds are not generally based on investment indexes. (Though they often measure performance against them.) They tend to be more free-ranging, offering almost unlimited investment management strategies.

For example, a mutual fund may invest in only 20 or 30 stocks, looking to take advantage of certain trends in industries or with very specific companies.

Mutual funds also have almost unlimited investment classes. Similar to ETFs, they can invest in stocks, bonds, foreign stocks and bonds, emerging markets, and an almost unlimited variety of market industry sectors.

Unlike ETF’s, mutual funds seek to maximize capital gains.

The fund’s investment objectives are spelled out in his prospectus. Investors can choose a mutual fund by the objective, and by the success the fund has enjoyed in achieving those objectives.

As an investor in a mutual fund, you’ll commonly get tax information at year-end showing income from three sources: dividends, short-term capital gains and long-term capital gains.

“Active” Management

This is one of the fundamental differences between ETFs vs mutual funds. While ETFs are passively invested index funds, mutual funds have active management.

ETFs aren’t established to beat the market, and they won’t underperform it either. But the typical purpose of mutual funds is specifically to outperform the market.

This is the core of active management. The fund manager attempts to fill the fund with high-performing stocks while selling off laggards.

This is the reason why mutual funds generate capital gains. The buying and selling of securities take place when it’s deemed necessary in the case of each security. That will create either capital gains or losses.

The amount of trading activity in a mutual fund is measured by the portfolio turnover ratio. That’s the percentage of stocks in a fund that turnover in a typical year.

With an index-based ETF, that ratio will be well below 10%. But with mutual funds, particularly very actively traded funds, the ratio can be over 100%.

That means if the mutual fund normally keeps 100 stocks in the fund, there will be at least 100 trades during the course of a typical year.

Tax Implications of Active Management

Since most mutual funds are actively managed – some more than others – they tend to generate capital gains. Long-term capital gains receive favorable tax treatment. Once again, depending on your tax bracket, long-term gains are taxable at either 0%, 15% or 20%.

But short-term capital gains are taxable at your ordinary marginal tax rate. If that’s 22%, then that’s what you’ll pay on short-term capital gains.

On a particularly actively traded mutual fund, there may be a substantial amount of short-term capital gains income.

Because of the potential for taxable capital gains – as well as taxable dividends – mutual funds are often best suited to tax-sheltered retirement plans. This will avoid the tax liability they can create, particularly for high income taxpayers.

Mutual Fund Fees

Mutual funds come with two different fees: sales charges and expense ratios.

Sales charges, often referred to as shareholder fees, are basically load fees. They’re expressed as a percentage of the dollar amount of the fund purchased. For example, if you invest $5,000 in a fund, and the load fee is 2%, the load is $100.

Load fees vary from one mutual fund to another and generally don’t exceed 3%. But they can be charged as a front-end or back-end load. The front-end is a load charged on the purchase of a mutual fund. The back-end, sometimes referred to as a redemption fee, is charged on sale.

A fund may have one or the other, and sometimes both. For example, a common arrangement might include a 2% load on purchase, and 1% on sale.

In many cases, the redemption fee will be reduced or lowered if you hold your fund position for a certain amount of time. For example, a 1% redemption fee may only apply if you sell the fund within two years. After that, it disappears.

There are also many mutual funds that charge no load fee, and they’re referred to as “no-load funds”.

No-load funds should generally be favored, particularly if you trade fund positions frequently.

Expense ratio represents the expenses required to operate the fund. The amount of these expenses varies widely from one fund to another.

The expense ratio can include 12b-1 fees, as well as record-keeping, custodial services, taxes, legal expense, and accounting and auditing fees. But the largest single component of the expense ratio is usually the fee paid to the fund manager or advisor.

Because of the additional expenses, mutual fund usually has higher annual expenses than an ETF. That’s in addition to load fees, where there charged.

The Benefits of Mutual Funds

The biggest advantage to investing in a mutual fund – as opposed to an ETF – is that they attempt to outperform the market. ETFs only match it.

Once again, the mutual fund manager attempts to stock the fund with high-performing stocks, while selling off underperformers.

One of the best examples is with what are known as value funds. These funds seek to invest in fundamentally strong companies that have been underperforming the market.

For example, a company may have been hit with a major lawsuit, causing its stock price to plummet. But after the lawsuit settles, and the company resumes normal business, its stock is well below that of its competitors.

A value fund invests in these kinds of companies, and it’s proven to be one of the most successful investment strategies over the long-term.

Warning: The vast majority of mutual funds fail to outperform their underlying index. In fact, only about 22% of mutual funds outperform for as long as five years. It’s not unlike trying to find a stock that outperforms the market.

You have to look very closely at the performance of the fund manager over the past five or 10 years to gauge the likelihood of outperformance. But even then, there’s no guarantee. A fund that has been outperforming the market for the past five years could underperform in the next five.

What’s that popular warning: past performance is not a guarantee of future results.

Yeah, that.

How and Where to Invest in Mutual Funds

Mutual funds are not typically available through robo-advisors. But they can be purchased through large investment brokerage firms, like Ally Invest, E*TRADE or TD Ameritrade.

Each offers a large number of mutual funds at very low trading fees. In fact, they typically charge no commission if a mutual fund has a load fee.

Another way to buy mutual funds is through a mutual fund family. These are companies that have a large number of mutual funds in virtually every investment niche.

The bigger ones have hundreds of different funds. Two of the biggest mutual fund families are Fidelity and Vanguard.

One of the disadvantages in buying mutual funds is they typically require minimum investments. On the lower end, you can sometimes find funds with minimums of $500.

But others may be $3,000 or more. However, these minimums are often waived for IRA accounts if you sign up for automatic monthly contributions.

The Differences Between ETFs vs. Mutual Funds – Is One Better than the Other?

ETF’s are gaining in popularity. But that doesn’t mean mutual funds don’t have a place in your portfolio.

ETFs certainly make sense in taxable investment accounts. Since they generate little in the way of taxable income, they can grow in value over time, and only become taxable when you begin liquidating them to make withdrawals.

In that way, ETFs are something of an informal retirement plan. You can use them to save for retirement, without housing them in a tax-sheltered retirement plan.

They’re also the perfect investment if you’re looking for a generally passive investment portfolio. In that case, your only real concern is maintaining the right asset allocations. Since they are low-fee, and index-based, they’re perfect for portfolio allocations.

ETFs can also be perfect for timing strategies. If you’re looking to play market trends, it’s easier to move in and out of ETF’s.

You’re betting on the market, and not any specific stocks within the index. And when the trend shifts, you can move out of an ETF, and into another asset class or cash.

But the potential to beat the market with mutual funds is valuable all by itself.

This is particularly true if you’re looking to invest in out-of-favor stocks. That’s actually a risky investment strategy if you were to try to do it on your own.

But as part of a mutual fund, run by a professional investment manager, you can invest in a portfolio of out of favor stocks. That will improve the chances of big gains in the long run.

You might choose a strategy in which you hold primarily mutual funds in tax-sheltered retirement plans, to eliminate the tax on capital gains. You can then hold ETF’s in taxable accounts, since the ETF’s generate little in the way of capital gains.

Final Thoughts on The Differences Between ETFs vs. Mutual Funds

Though there are many either/or debates in the investment world, not all are entirely valid. There are different investments – and investment vehicles – that serve a variety of purposes. True diversification is found in dividing your money among the many different investment choices.

Though it may be convenient to follow the herd and invest strictly in ETFs, we also have to admit that thinking has been generated by a stock market that’s gone straight up for the past nine years. Should that change, mutual funds may come back into favor, as investors look for a way to find gains in a less predictable market.