ETF (Exchanged Traded Funds) versus Mutual Funds (MF)

From the outside Exchange Traded Funds (ETFs) and Mutual Funds (MFs) look like the same financial products. A closer look at each of them reveals the many advantages and disadvantages of ETFs versus MFs. As for MFs I am only discussing open ended funds, not closed end funds. Regarding ETFs I will not consider exotic funds (for example, interest rate swaps and forward one month future contracts) or precious metals funds as these ETFs have different tax consequences.

Advantages of ETFs:

Significant cost advantage: Expense ratios are generally lower for ETFs than for comparable MFs. Vanguard offers very similar ETFs and MFs that follow the same index but the ETFs have much lower expense ratios. For example, the MF that tracks the Standard and Poor (S&P) 500 VFINX has an expense ratio of .18% versus ETF VOO for which the expense ratio is .06%. This is only a saving of US $12 on an investment of US $10,000 per year, but compounded over time it can add up to thousands of dollars coming out of investors’ pockets. There can also be a commission fee every time you buy an ETF (since you are buying a stock), but many brokerage firms will waive the fee if you buy their ETFs.

Buy or sell at any time: ETFs are just like stock – you can buy or sell them whenever you wish. Mutual Funds are processed once a day at the next closing net asset value (usually at the end of the day). Another advantage is you can place limit buy or sell orders (same as for stock).

Tax advantages (for non tax exempt account): ETFs do not distribute capital gains every year like mutual funds (except on rare occasions) so you will only have to pay the capital tax when you sell the fund.

No minimum investment amount: You can buy 1 ETF share or 100,000 shares. Most (if not all) MFs have an initial minimum purchase amount, for example, US $5,000 as well as a minimum reinvestment amount, for example, US $100.

You can short an ETF: Just as with stocks, you can short ETFs.

Disadvantages of ETFs:

No automatic dividend reinvestment feature: You have to reinvest the dividends (just like stocks). For most MFs you choose to automatically reinvest the dividends.

ETFs are only as good as the index: ETFs are passive (non-managed) funds that try to duplicate the performance of an index, for examples, S&P 500, Russell 2000, and others. This may be a positive since not all MF managers beat the appropriate index benchmark with which they are compared.

Can have high bid / ask spreads that are thinly traded and have small market capitalization: Always check if an ETF you are interested in is thinly traded or has a small market capitalization. The ETF liquidity could disappear in severe market conditions. Also, the spread between the bid and ask price can cause more expense when you are selling.

Advantages of MFs:

Automatic dividend reinvestment feature: As a mutual fund investor you can choose to automatically reinvest your dividends in the mutual fund.

Activity managed by MF manager (if not index fund): MF managers try to out-perform the comparable benchmark and peer funds through their selection of investments. This has the potential for out-performing the market.

Lower cost if buying shares on a monthly basis (no stock transaction cost): MF can have lower cost if buying shares every month.

Disadvantages of MFs:

High fees and sales loads: With MFs there can be sales charges on buying (front-end sales load) and redemptions (back-end sales load). These loads can be a maximum of 8.5% (most MFs do not charge the maximum). Mutual funds have higher fees than ETFs. The following are examples of the fees: management fee, non-management expense, and 12b-1/non-12b-1 fees.

Distribute capital gains every year (for non tax exempt accounts): Mutual funds are required by law to distribute capital gains each year (MFs must distribute 95% of the gains to shareholders). The capital gains distribution is a result of an MF selling shares. For example, if the market is going down the MF manager may have to sell shares because of the need to raise cash for shareholder redemptions.

Shares can only be sold when the market closes: Mutual Funds are processed once a day at the next closing net asset value (usually at the end of the day).

High minimum investments and reinvestments can be required: MFs can have high minimum initial investments. For example, Vanguard MFs have a minimum of US $3000 for initial investment.

Please chime in with comments about exchange traded funds versus mutual funds. Which ones have you been investing in lately?

© 2011 Paul Cusick

Paul