Mutual funds and exchange traded funds are two types of investment funds available to investors. Both types of funds pool capital from lots of investors, and both are professionally managed. There are a few other similarities, and quite a few fundamental differences.
Before deciding between the two, it’s important to understand the differences and objectives of each type of fund.
Similarities between Mutual Funds and ETFs
As mentioned, both mutual funds and exchange traded funds pool savings from multiple investors. This means investors benefit from economies of scale. Fixed costs are spread across the entire fund, reducing the burden on each individual investor. Variable costs are also reduced as funds typically pay wholesale fees for trading and administration.
The economies of scale also allow for funds to be managed by investment professionals. Unless an individual has a very large stock portfolio it would be very expensive to have the portfolio managed by an investment professional. By contrast, ETFs and mutual funds both give investors access to professionally managed portfolios for less than 1% of the value of assets each year.
Most investment funds offer diversification regardless of their structure. For a portfolio to be diversified, it needs to include 15 or more securities. Most mutual funds hold at least 30 different securities, while the average ETF is even more diversified. There are some exceptions though – the SPDR Gold Trust, an ETF, only holds physical gold and offers no diversification.
Indexes play a role in the management of both mutual funds and ETFs – however, ETFs track the index while mutual funds use the index as a benchmark against which performance is measured.
Differences between Mutual Funds and ETFs
Mutual Funds and ETFs are unique legal structures, and both are regulated. Mutual funds have been around since 1924, while ETFs have existed since 1993. In the US both are regulated by the SEC (Securities and Exchange Commission) and legislation which is updated from time to time. Similar regulatory bodies oversee funds in other countries.
Active vs. Passive Management
While both types of funds have different legal structures, the most fundamental difference lies in the way they are managed.
Market outperformance is known as alpha, while the performance of the market (or an index) is known as beta. The objective of actively managed funds is to earn both alpha and beta by outperforming an index. The objective of passively managed funds is to earn beta by tracking the index.
Asset management companies manage actively managed funds. A fund manager will have overall responsibility for each fund but will be supported by a team of analysts. These analysts conduct ‘bottom up’ research on individual securities. Together the team attempts to generate alpha by deciding which securities to buy and sell, and when to do so.
Smaller teams manage passive funds, and the fund managers and analysts often have a background in quantitative analysis. The objective of a passive fund is to mirror the performance of an index by holding securities in exactly the same proportion as that index. Changes to the fund’s allocation are only made when changes are made to the index.
The vast majority of mutual funds are actively managed – though some are passively managed. By contrast, the vast majority of ETFs are passively managed. Actively managed ETFs have been allowed in the US since 2008, but still account for small percentage of funds.
The implication of the different management styles is that if you invest in a mutual fund you are expecting to earn alpha and beta, while you would only expect to earn beta from an ETF.
Expense Ratios (Mutual Funds vs ETFs)
Fund management companies charge various fees to cover management and operational costs. These fees are reported as expense ratios, which reflect all fees charged each year, expressed as a percentage of the fund’s value.
Mutual funds charge substantially higher fees (on average) than ETFs. Expense ratios for mutual funds average around 0.65%, though they do vary considerably. Expense ratios for ETFs average around 0.2%, but also vary. Expense ratios for both can be as high as 2% for very specialized funds.
The reason for the difference in fees is that active management requires more manpower. As many as 30 analysts may contribute to the management of a mutual fund. On the other hand, just two or three people manage some ETFs.
Mutual funds justify the higher fees because they attempt to earn alpha as well as beta. However, there is no guarantee that a mutual fund will earn alpha. In fact, if a fund underperforms its benchmark, it is not even earning beta, and the cost is effectively higher.
Pricing (Mutual Funds vs ETFs)
When you buy an ETF, you are buying shares…