An Unfair Comparison: ETFs and Mutual Funds

mutual-vs-efts

Mutual Funds (MFs) and Exchange Traded funds (ETFs) each come with their own set of pros and cons and it can be difficult to determine which to invest in.

MF

Let’s start by taking a look at the basic Mutual Fund, commonly referred to as an MF. The concept of MF:s is much older than that of ETF:s and it is easier to understand what an ETF is if one already knows the ins and outs of MF:s.

A mutual fund is an investment vehicle comprised of a pool of funds collected from many investors. An investment fund can invest in many different things, including stocks and bonds. These investments are made by money managers who operate the fund.

One of the reasons why small investors invest in MF:s is that by doing so, they get access to professional money managers. Investing in an MF can also be a way of spreading risk, e.g. by investing in a highly diversified MF that owns equities, bonds and other securities divided over various segments of the economy and/or geographical regions.

Units (shares) of the MF can typically be bought or redeemed as needed at the fund’s current net asset value per share (NAVPS). The net asset value of an MF is the total value of the portfolio divided by the total amount of outstanding units.

Costs

Before investing in mutual funds, it is important to check the management expense ratio (MER), management fees and sales charges – and how they are calculated. These costs can make a big dent in your investment over time, due to the impact of compound interest. A $100 cost today doesn’t just cost you $100; it costs you all money that a $100 investment would have generated for you over time. Information about costs should be found in the MF:s prospectus.

Some costs are not openly borne by the investors, but will impact the overall return of the MF. This is why it is important to also check out figures such as the trading expense ratio (the direct transaction costs for the buying and selling carried out by the MF). Marketing costs, staff costs, legal costs, insurance costs, auditing costs, administration costs and more are all costs that will be borne by the MF and thus impact its overall return.

Actively traded mutual funds tend to incur a lot of costs due to the frequent trading.

No-load MF

A no-load mutual fund is sold without a commission or sales charge. No-load MF:s are distributed directly by un investment company.

Open-ended vs close-ended

An open-ended mutual fund is constantly open for new investments, both from new investors and from investors that already own units of the fund. When someone buys into the fund, new units are created. The price paid for these newly created units depend on the net asset value (NAV) of the fund.

With a close-ended mutual fund, a set of units is created when the fund is formed and that’s it. If you want to invest in the fund later, you must find someone that’s willing to sell you already existing units of the fund. This is true both for new investors and for investors that already own units of the fund and want to increase their holding. N.B! In quite a few jurisdictions, it is legally permissible for a close-ended investment fund to create new units. However, that is normally only done when the fund has become so popular that the demand for units is considerably larger than the number of units available on the market. It is not routinely done every time someone wants to buy into the fund. When new units are created by a close-ended mutual fund, it will typically cause a noticeable decrease in the market price of the units.

ETF

An Exchange Traded Fund (ETF) consists of units that are listed on a stock exchange. The ETF tracks something, such as a stock index, a sector or a commodity.

An inverse ETF will track the opposite return, e.g. an ETF that tracks the commodity price of gold in a way that means that the ETF gains when the price of gold goes down.

Compared to the traditional mutual fund, ETF:s usually have lower fees and the liquidity for the units is higher. Since ETF units are listed on a stock exchange, it is easier for potential buyers and sellers to find each other and carry out transactions. ETF:s are frequently sold short, purchased on credit (margin account) and so on, in a fashion very similar to how stocks are traded.

While a mutual fund has its net asset value (NAV) calculated at the end of each day, this is not true for the ETF. It should be noted however that the ETF:s holdings are disclosed publicly each day.

Capital gains from sales inside the ETF are not passed through to the shareholders. From a taxation point of view, this is an important aspect of the ETF and is one of the things that distinguishes it from a traditional MF.

ETF:s are always open-ended. Authorized participants (AP:s) create and redeem units, thus controlling the supply. Most AP:s are banks or investment corporations. The AP assembles a portfolio of underlying assets and hands it over to the ETF, receiving newly created units in exchange. When an AP returns EFT units to the EFT and receives underlying assets in exchange, it’s called redemption.

Exemples of well-known ETFs

Name What does it track?
BHH The biotech sector
GLD Gold (commodity price)
DIA Dow Jones Industrial Average Index
SPY S&P 500 Index
QQQ Nasdaq 100 Index

Costs

Just as with a mutual fund, some of the profits will be used to pay for expenses incurred by the ETF, e.g. transaction costs, costs related to creation and redemption, marketing costs, legal costs, fund manager costs and other staff costs.

For you as a buyer, it is also important to know how much your broker will charge you. Since ETF:s are exchange traded, buying and selling through a broker is the norm. If you trade frequently, it can become very expensive.

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