ETFs vs. Mutual Funds: The Ultimate Guide

by on December 22, 2009 | Updated November 1, 2012 | ETFs Mentioned:

It’s no secret that actively managed funds have fallen out of fashion. Many big names have touted the benefits of financial instruments that track an index, and ETFs such as SPY and VTI have enjoyed huge asset inflows as a result. Legendary investor Warren Buffett is even on board, announcing that “a very low-cost index is going to beat a majority of the amateur-managed money or professionally-managed money.” (Buffett actually recommends index mutual funds over ETFs because they discourage trading, but there’s no question that the trend toward indexing is driving the growth of ETFs.) And while the asset management industry isn’t a zero-sum game, it’s clear that the growth of ETFs is occurring at the expense of the mutual fund industry. [For more ETF analysis, make sure to sign up for our free ETF newsletter or try a free seven day trial to ETFdb Pro]

ETFs vs. Mutual FundsThe love affair with ETFs is not just a passing fad. It’s true that the total assets in exchange traded funds are dwarfed by those in mutual funds. But ETFs were only introduced in 1993, and didn’t gain widespread acceptance until recent years. ETF assets in the U.S. now total more than $750 billion, and the industry has seen more than $200 billion in cash inflows over the last two years. It’s not inconceivable that within a few decades, total ETF assets will exceed total mutual fund assets.

ETFs Vs. Mutual Funds

The differences between mutual funds and ETFs are both numerous and material, based on fundamentally-different approaches to investing and views of financial markets. Specifically, differences include:

Alpha vs. Beta

Most mutual funds employ teams of analysts, quantitative analysis, and other methodologies in an attempt to outperform a certain benchmark. The Fidelity Fund (FFIDX), for example, invests in large cap domestic equities and strives to deliver a return greater than that of the S&P 500.

Instead of trying to generate alpha by beating a benchmark, ETFs own the entire index to deliver the beta of the benchmark. The SPDR S&P 500 ETF (SPY), for example, seeks to match the performance of the S&P 500. Utilizing a “passive” investment strategy allows ETFs to charge much lower expenses to investors: SPY has an expense ratio of 0.09%, while FFIDX charges 0.64%. And the Fidelity Fund is on the low end of the cost range for mutual funds — some can charge as much as 1.50% annually.

Weighted average expense ratios for many of our all-ETF Model Portfolios are less than 0.20%, a fraction of the fees paid my mutual fund investors (if you don’t have access to our model portfolios, sign up for a free trial or read more here).

Liquidity

Mutual funds can be redeemed by investors at net asset value (NAV) at the end of a trading day. ETFs trade like stocks, meaning that they can be bought and sold whenever the markets are open assuming that an investor can find a counterparty willing to purchase the ETF shares.

Because mutual fund shares are redeemed at net asset value, investors don’t have to concern themselves with selling their holdings at a discount to fair value (or buying in at a premium). The same can’t always be said for ETFs. While there are arbitrage mechanisms in place to prevent ETFs from trading at a price significantly above or below the market value of the underlying holdings, gaps between NAV and market price do emerge sometimes, particularly in thinly-traded ETFs.

Redemption Process And Taxes

When mutual fund investors decide to sell, shares are redeemed by the fund manager in return for cash. ETF shares can also be redeemed in exchange for cash proceeds, but only by certain Authorized Participants. When most ETF investors decide to sell, they do so to another investor (again, much like stocks are bought and sold). Similarly, when investors are looking to purchase an ETF, they typically buy not from the fund manager but from another investor. This means that ETF investors may want to utilize limit orders when trading, especially when placing a large order. If the market for a particular ETF is relatively shallow, market orders can lead to big run-ups in price, placing investors in a hole from the very beginning

On the surface, the net result to investors is the same: shares are sold and they end up with cash equal (or roughly equal) to the market value of the shares in their pockets. But the tax impact that comes down the road may be very different. Mutual funds may have to sell assets in order to make a cash payment to a redeeming shareholder, thereby incurring capital gains on stocks that have appreciated. This may result in a taxable event for the remaining shareholders, putting them at the mercy of the buying and selling habits of other investors.

ETFs won’t keep the tax man at bay indefinitely, but they are generally more tax efficient than mutual funds. Because investors wishing to sell ETFs deliver the shares to another investor, there is no redemption process and no need to sell any of the ETF’s underlying holdings.

Minimums

Many mutual funds require a minimum investment to buy in, sometimes as high as $50,000. ETFs have no minimum investment — investors wishing to purchase a single share have the ability to do so (although the impact of commissions on overall return would pose a problem) [see Free 7 Simple & Cheap All-ETF Portfolios].

Short Selling And Options

Options for investing in mutual funds are pretty elementary: you either buy one or you don’t. But ETFs open up a whole different range of investing possibilities. ETFs can be sold short, essentially allowing investors to bet on a decline in the index tracked by the fund.

Options are also available on many ETFs, significantly expanding the number of strategies that can be employed. These tools are probably only appropriate for more sophisticated investors, but can be very powerful if used correctly.

Dividends

Most mutual fund investors take advantage of the automatic dividend reinvestment option, electing to purchase additional shares (or partial shares) with with any cash received. ETFs act more like stocks in this regard as well, meaning that any dividends paid wind up in an investor’s brokerage account. ETF investors are then required to make another purchase to put this money back to work, potentially incurring transaction costs (although many brokers allow no-cost reinvesting) [see Actionable ETF Trading Ideas]

Five Trends That Show ETFs Are “Winning”

The rise of the ETF industry, in part at the expense of traditional mutual funds, is not disputed by many investors. But for those who have a hard time believing that ETFs really are the future of investing, there are some compelling statistics to support this thesis:

  1. Investor assets are shifting from mutual funds into ETFs. See this Financial Research Corp. study, April 13, 2009, via WSJ:

    Consider this: for every $100 invested in 2001, $90 went into mutual funds, $8 went into index funds, and $2 went into ETFs. Fast-forward seven years: By the end of 2008, the share of mutual funds fell to around $81.5, while index funds attracted $9.5 and the remaining $9 went into ETFs.

  2. Investor interest is shifting from mutual funds to ETFs. See the Google Trends statistics, 2004-2008, via Rock the Boat Marketing:

    Typically, search volume is believed to be a proxy for relevance. In that context, the decline in searches for “mutual funds” at a time when mutual fund news references (see second, smaller graph) were actually higher than in previous years is just something that could cause one to invoke Jeff Foxworthy–you know, the comedian who tracks “things that make you go Hmm.” The difference in the scale between the volume on the two search terms is support for the idea that ETFs are only gaining in popularity.

    Check out the most recent comparison graph at Google Trends:

    Google Trends: 'Mutual Fund' vs. 'ETF'

  3. Investor advisors and financial planners favor ETFs. Check out the recent survey by Charles Schwab, via Forbes.com:

    ETFs with their liquidity, transparency and cost efficiency are making their way to frontline investors. In fact, among a recent survey of Registered Investment Advisors by Charles Schwab, a full 79% say they now look to ETFs as their top investment vehicles for their clients.

  4. Investment in “alternatives” via ETFs is growing. Refer to the recent survey by Cerulli Associates via Financial-Planning.com:

    “We found that if you look at practice types—wealth managers, those in wirehouses and RIAs (registered investment advisory firms)—they use alternatives.”  More specifically, they are relying on a certain type of ETF—those that are invested in currencies and commodities, she said.

  5. The bottom line: ETFs outperform mutual funds. OK, this isn’t a study, simply a logical analysis in the article “Boot Weak Mutual-Fund Managers For Solid ETFs” at WSJ.com:

    “If you’ve got 100 managers all playing in the same sandbox, the index fund has to be in the top half because it has less expenses,” [financial adviser Harold] Evensky [of Evensky & Katz in Coral Gables, Fla.] said. “And since the active managers in the top half don’t stay there all the time, the index over time gradually moves up. [...] If I can be guaranteed funds that are always in the top half, that’s pretty good,” he added, “as opposed to trying to pick one that’s going to be on top but may also end up on the bottom.”

The mutual fund industry isn’t going to die next year–or in the next decade. Active fund management will always have its place. But there’s no question that the convenience, efficiency, and performance of ETFs will ensure their continued growth, probably at the expense of less-useful financial instruments. And that’s a good thing for investors everywhere.

ETFdb Pro members can learn about all of the latest developments in the ETF industry in our monthly newsletter, ETF Edge. If you’re not a Pro member yet, sign up for a free trial or learn more here.

Disclosure: At the date of publishing, the author currently owns shares of an ETF mentioned in this article: VTI.