Mutual Funds have been a popular way to invest for several decades. On the other hand, Exchange Traded Funds or ETFs as they are commonly known, are relatively new but are quickly gaining popularity for their low-cost and their better tax treatment. There are some differences of which you should be aware.
As a review, a Mutual Fund is an investment which contains a pool of different shares of individual stocks and or bonds, which are specifically chosen by a Fund Manager or the funds’ management team.
The price of a Mutual Fund does not vary during the course of the trading day because it is set at the end of each trading day. You buy or sell a Mutual Fund at the end of the day after the price for that day has been set, based on the value of the individual investments in the Fund. So if the price of the Mutual Fund you want to buy is $45.00 per share and you place an order to buy $10,000 you will acquire 22.222 shares at the end of the day.
All Mutual Funds have expenses including commissions, redemption fees and operational expenses. Commissions or loads as they are sometimes called are either front-ended or back-ended, meaning you pay a commission when you either buy or sell, respectively. There are also no-load or non-commission Mutual Funds and are much preferred. Redemption fees are to discourage excess turnover and occur only if the fund is sold prior to a specific period of time. Operational fees include managements’ expertise and miscellaneous fees such as for advertisement or distribution expenses. On average, Mutual Fund annual expenses can range from as little as 0.1% to as much as 3% or more per year. These expenses are not seen by the investor on the monthly statements and are somewhat hidden and can have an impact on your overall return
Exchange Traded Funds
ETFs have several similarities to Mutual Funds. Like a Mutual Fund, an ETF is a pool or basket of investments. However, ETF’s many times have lower expenses then a similar Mutual Fund in that there are no loads and the operating expenses are often lower. FINRA posted the following comparison of expenses on its website.
|Fund Type||Average Total Operating Expenses|
|US Large-Cap Stock||1.31%||0.47%|
|US Mid-Cap Stock||1.45%||0.56%|
|US Small-Cap Stock||1.53%||0.52%|
Another primary difference is that an ETF doesn’t trade at the end of the day like a Mutual Fund. The price of the ETF is determined by investor demand at any given time during the trading day.
How to Buy ETF’s
ETF’s are bought and sold like stocks. There is the bid price from buyers and the ask price from sellers. When you go to buy an ETF you do not place an order for $10,000. If you want to invest that amount you need to determine the number of shares to buy.
To start, look at the bid and ask price and figure that what you will pay will be somewhat close to those numbers. Lets say that the bid for an ETF that you are interested in is $45.15 and the ask is $45.18. Divide $10,000 buy the ask price $45.18 and you get 22.1337 shares. You would place an order for 22 Shares. A short time later your order will be filled and you will learn the exact price that was paid. Let’s say that the order was filled at $45.17. You will pay $993.74 for the shares and there will be a transaction fee from your custodian to place the order. Let’s say it was $9 for the trade. Therefore you paid a total of $1002.74 for your 22 shares of the ETF.
The “spread” which is the difference between the highest acceptable buy price and the lowest acceptable sell price can vary based on the volume of selling and the demand for the shares. While the bid-ask spread might be only 1 penny in the case of widely traded ETF’s it might also have a much wider spread for a less liquid ETF. If you are going to buy a large order of a lightly traded ETF, you would be well served to buy in several smaller orders to avoid a big increase in the spread. Talk to your advisor or custodian about this if you are unfamiliar with this topic.
ETF Tax Efficiency
ETF’s are more tax effective than Mutual Funds. An ETF’s ability to decrease or avoid capital gain distributions comes from two differences: Unlike Mutual Funds where shares are redeemed with the Fund directly, ETF’s are traded on an exchange just like a stock. When one party sells the ETF and another buys on the exchange so the underlying securities within the ETF are not sold to raise cash for the redemption, therefore no gain- no tax. The redemption process also enables the fund manager to sell the most effective cost-basis stocks through stock transfers during the redemption or creation process. These characteristics can also mean a difference in the after-tax rate of returns from a Mutual Fund versus an ETF, even when they both replicate the same underlying index.
Perhaps this was more than you ever wanted to know about the similarities and differences of a Mutual Fund and an Exchange Traded Fund but it certainly doesn’t hurt to be informed, after all, information is power!