The Difference Between Mutual Funds and ETFs

This is a question we get a lot here at Callahan Financial Planning, and with all the recent news and new options, I thought it would be a good topic to revisit.

As a refresher, let’s start with a quick note on what Mutual Funds are:

  • An Investment Company that invests shareholders money in a (usually) diversified portfolio of securities like individual stocks or bonds.
  • Assets are held in custody at a third-party bank, and are subject to regular inspection by the SEC in addition to any independent auditors to the bank and mutual fund.
  • The Investment Company (the Mutual Fund) is overseen by an independent Board of Directors whom are charged with ensuring the fund is managed in the best interest of the fund’s shareholders (investors).
  • The idea is to make diversification easier by grouping investments together, and to reduce the costs associated with investing by spreading transaction costs amongst thousands of investors. A Mutual Fund can either be “actively” or “passively” managed. This refers to whether an individual or team have discretion over day-to-day investment choices on your behalf, or they simply follow an index of stocks meeting a specific predefined criteria. The majority of Mutual Funds are actively managed.
  • Their well implemented, managed and regulated nature allows for their day-to-day liquidity. This means you can see their updated market price daily and always know the value of your portfolio, in cash, at any given time. The Mutual Fund stands ready to buy back your shares from you at the set-daily market price.
  • Mutual Funds have annual expense ratios anywhere from 0.10% to 3.00%. This is the percentage of your money that goes towards paying for the investments each year and pays for all the expenses associated with maintaining the fund. The average annual expense ratio in 2010 for a stock mutual fund was 0.84%.
  • Mutual Funds are commonly sold with a sales commission, known as a sales charge or “load”, ranging from 1.00% to 8.50% of your investment. This is in addition to your annual expense, but can be avoided with good planning or assistance from a Fee-Only Financial Advisor (the “Fee-Only” means you pay an Advisor a flat fee, typically hourly or annually, for advice instead of a sales commission).
  • Finally, income taxes can be incurred through capital gains, dividends or interest earned from investments the fund owns (reported and distributed annually) or by a gain made upon the sale of the fund.

Mutual Funds have become an important part of saving, with more than half of Americans having reported owning them. There are more Mutual Funds in the U.S. today than there are individual stocks.

ETFs, on the other hand, are relatively new. Whereas Mutual Funds date back to 1924, ETFs didn’t appear until 1993. There are several advantages and just a few (potential) drawbacks. The important thing to remember with ETFs, like Mutual Funds, is there are several types with differing characteristics.

Here are the basics of ETFs:

  • Like Mutual Funds, ETFs are an Investment Company that invests shareholders money in a (usually) diversified portfolio of securities like individual stocks or bonds.
  • Assets are held in custody at a third-party bank just as with a Mutual Fund, and are subject to regular inspection by the SEC in addition to any independent auditors to the bank and ETF.
  • The Investment Company (the ETF) is overseen by an independent Board of Directors whom are charged with ensuring the fund is managed in the best interest of the fund’s shareholders (investors).
  • The idea is to make diversification easier by grouping investments together, and to reduce the costs associated with investing by spreading transaction costs amongst thousands of investors. Until recently, investing in an ETF always meant “passive” management. While “active” management starts to become available in ETFs, the vast majority simply follow the investments that make up whatever index they are supposed to follow. With the surge in popularly of ETFs, there has been a similar corresponding increase in the availability of specialized indexes to follow, often created just for a new ETF.
  • Their day-to-day liquidity comes in a different format. Instead of the option to sell your shares back to the Investment Company once every day, you can sell them at any time to a willing buyer on a stock exchange, just as you can with an individual stock. As with stocks, the level of marketability/liquidity is relative to how many buyers/sellers there are available for a specific security. This means the bigger the ETF, the more liquidity. Additionally, ETFs typically have a “creation and redemption” process that, in the absence of a willing buyer/seller, allows you to convert an ETF for its underlying shares or vice-versa. This helps keep pricing close to the value of the investments and keeps transaction costs low.
  • ETFs are known for their tax efficiency. This is primarily due to the creation and redemption process, which in effect has mostly limited capital gains to transactions done by an ETF owner, but not within the fund itself. There are some exceptions to this rule, however. Theoretically done properly, one could own a successful stock ETF for decades and not have to pay income taxes until sold (assuming no dividends).
  • ETFs have annual expense ratios anywhere from 0.05% to 1.00%.  The average annual expense ratio in 2010 for a stock ETF was 0.41%, less than half of the Mutual Fund average (with most ETFs actually available for much less than 0.41%, even).
  • ETFs are always sold without a sales commission or load, but may have transaction costs (trading commissions) at the brokerage you purchase them through.

Aside from a few exceptions (such as ETNs, commodity or futures ETFs) basic ETFs can reduce the cost of investing significantly, provide better clarity and control over what investments you own and incur less income taxes with ownership.

If you have questions about investing in ETFs, a Fiduciary, Fee-Only Financial Advisor at Callahan Financial Planning can help.

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Author: William A. Callahan, CFA, CFP®

William is a Certified Financial Planner™ practitioner and Chartered Financial Analyst charterholder. He serves as President and Chief Investment Officer at Callahan Financial Planning Company in Omaha and Lincoln, NE and San Francisco, San Rafael, and Mill Valley, CA.