I enjoy teaching clients the value of low-cost asset class diversification. Every investment position in a portfolio should serve a purpose, and that purpose should not be to benefit your broker. Remember that the stock market has a way of transferring money from those with egos, impatience, and emotions to those that have an indexing strategy patiently executed.
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A basic goal for many investors is to gain their desired market exposure in the most efficient and cost-effective way possible. That goal is most frequently achieved by investing in either mutual funds1 or exchange-traded funds (ETFs).
Although mutual funds have a far longer history and continue to hold a larger share of invested assets in the U.S., ETFs have experienced explosive growth in the last ten years (Exhibit 1). ETF growth has been spurred in part by trends favoring low-cost, passive investment approaches. As the number of firms offering ETFs and the number of strategies available in ETF form have steadily increased, so has the level of investor comfort with using ETFs as all or part of a broad investment strategy.
Source: Investment Company Institute. Mutual Fund data excludes assets in money market funds.
However, in cases where both options are available, investors may wonder whether mutual funds or ETFs are a better choice. We believe that both can help investors meet their long-term goals, and that both are generally more desirable approaches than purchasing individual securities. We also believe there are several key contrasts worth considering when choosing between the two, and that those contrasts favor the use of ETFs in most cases.
Prior to delving into the differences, we provide a brief review of some of the ways in which mutual funds and ETFs are similar:
With the above similarities as a backdrop, we now turn to areas of differentiation that may assist in evaluating the relative merits of each type of portfolio.
Despite the ongoing trend of investors moving from actively-managed strategies to passive index-tracking strategies, the majority of mutual fund assets remain in active strategies.
By contrast, the ETF market has primarily evolved as a way for investors to gain passive exposure to various asset classes in a liquid and cost-effective vehicle (Exhibit 2). As discussed in later sections, the use of passive ETF strategies typically entails lower costs and more favorable tax consequences relative to actively-managed mutual funds.
Source: Investment Company Institute. ETF data excludes funds not registered under the Investment Company Act of 1940.
The most noticeable difference between the two vehicles is in the way they are accessed by investors. While an investor may place an order to purchase or sell mutual fund shares at any time during the day, the trades are not actually executed until the end of the trading day. All trades for a given mutual fund are priced using the fund’s closing NAV for that day. The fund’s total number of shares outstanding is then adjusted up or down based upon that day’s net purchase and sale activity.
ETFs are traded on market exchanges, in the same manner as stocks. Therefore, unlike mutual funds, trade execution for ETFs may occur at any time during the trading day. Although ETFs also have a NAV, the market prices at which ETF shares are bought or sold on the exchange will usually differ slightly from the underlying NAV based on the relative demand for the shares (e.g. high demand for a given ETF may cause it to trade at a small premium above its NAV). As long as supply and demand are relatively balanced, the number of shares outstanding will remain unchanged from day to day, as investors who want to buy the ETF simply purchase existing shares in the open market from investors who want to sell.
If, however, there is an imbalance between supply and demand, additional ETF shares may be issued on the exchange to satisfy excess demand (a process known as “share creation”) or existing ETF shares may be retired to soak up excess supply (a process known as “share redemption”). By helping to balance supply and demand, this creation and redemption process can prevent the ETF’s share price from diverging too far from the underlying NAV.
The contrast in trading mechanics is an important functional difference to understand, as it impacts the way an investor accesses the two products. Beyond that, however, the practical implications for long-term investors are negligible. The intra-day trading of ETFs is more relevant for investors who are seeking to transact frequently, as opposed to a buy and hold investor who is less motivated by short-term price swings.2
Another key difference that may be especially pertinent for many investors is the tax efficiency of ETFs. Mutual funds and ETFs are each required to distribute both earned income and realized capital gains to investors at least annually. This creates a current-year tax impact for investors who own the shares outside of tax-exempt or tax-deferred accounts.
Distributions of earned income are driven by the dividends and interest received from portfolio investments. In general, a mutual fund and an ETF with similar security holdings and similar investment goals are likely to generate similar levels of income distributions. The primary difference in tax consequences between the two vehicles therefore lies in the frequency and size of capital gain distributions. ETFs have historically generated far fewer capital gain distributions than their mutual fund counterparts (Exhibit 3).
Source: Morningstar, as of 12/31/2018
There are two main reasons for this. First, because the vast majority of ETFs are passively-managed vehicles designed to track a particular index, the level of trading and turnover in portfolio holdings is likely to be lower than in the average actively-managed mutual fund. Less selling of positions over time should on balance lead to lower realized capital gains being passed through to the fund investor.
Second, and perhaps more important, is the manner in which investor redemptions are processed. Often, when a mutual fund has net investor redemptions, the mutual fund manager must sell securities to generate cash to pay out the redeeming shareholders. This is true of both active and passive mutual funds. While most managers consider tax consequences in deciding what to sell, at times it may be difficult to avoid selling securities at a gain.
In the case of ETFs, the share redemption process described in the prior section can be accomplished without having to sell portfolio securities in the open market. In this process, a broker purchases the excess supply of ETF shares on the exchange from investors who want to sell. The ETF manager then sends a basket of portfolio securities to the broker in exchange for the ETF shares that are being retired. Because this “in-kind” exchange of portfolio securities for ETF shares is not a taxable event, the remaining shareholders in the ETF are not subjected to capital gains.
It is important to note that ETFs are not a panacea for completely avoiding capital gains. When an investor eventually sells ETF shares that have appreciated in value, a capital gain will be triggered on the sale of those shares. It is the lower taxable gain distributions during the investor’s holding period that give ETFs their advantage. This advantage, which essentially represents a deferral of tax, is particularly relevant to patient investors who plan to retain their ETF shares as part of a long-term strategy.
Investors may purchase mutual funds through a variety of distribution channels. In some cases, fund shares are purchased directly from the fund company that manages the portfolio. This is usually the most cost-effective way to transact in mutual fund shares. Shares may also be purchased through financial intermediaries such as brokers and investment advisors, some of whom earn a commission on the sale of those shares to their clients. The costs associated with distributing the funds through those intermediaries is borne by the investor in the form of higher expense ratios (often through the addition of a 12b-1 marketing fee), front-end sales loads, and back-end sales loads, among other things.
Because ETFs are exchange-traded, there are no additional distribution charges associated with them. Since investors trade ETF shares through a brokerage account3, there may be a trading commission paid on each trade. Some brokerages mitigate this cost by offering discounted or even zero-commission trading.
ETF investors are also subject to the bid/ask spread, which represents the difference between the price at which an ETF can be purchased on the exchange and the slightly lower price at which it can be sold. The bid/ask spread compensates brokers for the risk associated with holding and trading the ETF and is generally higher for riskier ETFs that trade less frequently. As a rule, ETF investors can keep execution costs extremely low by trading less frequently (i.e. using ETFs as longer-term strategic investments) and by utilizing large ETFs that have a deep market of buyers and sellers.
Apart from trading and distribution costs, management and other fees for mutual funds are higher on average than for ETFs. However, this is largely driven by the aforementioned predominance of actively-managed strategies in the mutual fund world (Exhibit 4). Management fees for active strategies within a given asset class tend to be significantly higher than for comparable passive strategies. In practice, an investor interested in a passive strategy with a low management fee is likely to be able to find an acceptable solution through either mutual funds or ETFs. For example, the Vanguard 500 Index Admiral Shares mutual fund and the Vanguard S&P 500 ETF, both of which passively track the S&P 500 index, have expense ratios of 0.04% and 0.03%, respectively4.
Source: Investment Company Institute. As of 12/31/20
A less critical but still relevant difference between mutual funds and ETFs lies in the public disclosure of portfolio holdings. Most mutual funds only publish a complete list of their holdings on a quarterly basis as required by the SEC, and even that is on a lag of 30 days or more. So an investor who is interested in learning more granular detail about the underlying portfolio is typically only able to gain that insight as of four discrete days throughout the calendar year, and at a point in time where the information is stale and therefore perhaps less relevant.
Most ETFs, on the other hand, publish a complete web-based list of holdings on a daily basis. The average investor may admittedly find limited value in the ability to access holdings information more frequently, particularly for a pure indexing strategy where the fund or ETF owns every security in the index in proportion to its size in the index.
However, in certain instances, the accessibility offered by ETFs could provide some value. For example, if a given security issuer is the subject of negative headlines, it becomes much easier to understand the exact level of current exposure the ETF has to that issuer. Similarly, an investor who is interested in determining how much true diversification will be achieved by purchasing multiple ETFs could easily compare current holdings across those ETFs to determine how much overlap exists among the portfolios.
Both mutual funds and ETFs offer investors of all sizes an efficient way to build a diversified investment portfolio. We believe the use of either of these vehicles as part of a disciplined, cost-conscious, long-term plan can significantly increase the likelihood of meeting an investor’s goals.
However, there are some important differences between the two vehicles that may lead the average investor to favor ETFs. Among these are:
1. For purposes of this discussion, we use the term “mutual fund” to refer to the open-end funds utilized by the vast majority of mutual fund investors. Closed-end funds and unit investment trusts, which each share some similarities with both open-end mutual funds and ETFs, hold a much smaller share of investor assets in the U.S. Therefore, we have elected to limit the discussion to the vehicle most relevant to the average investor.
2. Ironically, the late John Bogle, who invented the index fund concept as the founder of Vanguard Group, was often an outspoken skeptic of ETFs. However, this was less about ETF mechanics and more about his fear of how people would use ETFs. Bogle felt the intra-day trading of ETFs could encourage the type of speculative, rapid-fire portfolio turnover that he believed was so detrimental to investors. Our philosophy aligns with his, as we utilize ETFs to implement long-term, low turnover investment plans.
3. This point is relevant for investors who have all or a large portion of their investments in company-sponsored retirement plans such as 401(k) or 403(b) accounts. The investment menus of most such plans do not present access to a brokerage account, and therefore do not present access to ETFs. In these cases, low-cost index mutual funds may be present as a substitute. In general ETFs can be accessed through an IRA account or a taxable brokerage account.
4. Expense ratios are as of June 2021.
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