Building a balanced portfolio with individual stocks can be expensive and time-consuming. If you’re looking to save for retirement, or you hope to earn supplemental income by dipping your toes in the market, you probably can’t afford to purchase dozens of individual stocks in appreciable quantities. Not to mention, brokerage commissions on smaller purchases of individual stocks can add up quickly. For example, if you can only afford to purchase a few shares of a $25 stock, the typical $7 to $10 commission for your purchase would account for a significant piece of your total investment.
Mutual funds and exchange-traded funds (ETFs) enable individual investors with limited resources to increase their buying power, participate in a wider range of market activities, diversify their portfolios, and avoid the hassle of purchasing individual stocks. Some options, known as no-load funds, even eschew commissions. And while mutual funds and ETFs are often grouped together in a way that makes them seem interchangeable, there are a few important factors that differentiate them.
What Is a Mutual Fund?
A mutual fund uses the combined funds of hundreds or thousands of investors to purchase securities, including stocks, bonds, CDs, and money market funds. All mutual funds have specific objectives, for instance, they might focus on a particular sector or industry, or generate a predetermined rate of return or income. An index fund, a popular type of low-cost mutual fund, exists to mirror the performance of a financial index, such as the NASDAQ or the price of gold.
Mutual funds, including index funds, can generate capital gains through value appreciation of the funds’ component securities. They can also provide income through dividend or interest payments generated by those components. To support the fund, mutual funds charge fees, including load fees and expense ratio, that range from less than 1% (for passively managed index funds) to 5% or more (for certain actively managed funds) of the total amount invested.
There are two broad types of mutual funds:
- Actively Managed Funds. Actively managed mutual funds are overseen by one or more professional money managers. These funds contain any combination of securities (including individual stocks, bonds, and commodities) that have been selected by the fund manager to meet the fund’s objectives. These objectives fall into a number of overarching categories. For instance, global or international funds seek to invest in specific overseas markets, while balanced funds seek a particular mix of income and appreciation by allocating fixed proportions of capital to certain types of securities. When an individual security becomes ill-suited to meet the fund’s goals – whether due to poor performance or a failure to match the fund’s criteria for inclusion – the fund manager may reduce its weight within the portfolio or eliminate it altogether. Conversely, funds can also be increased or added to meet the fund’s objectives. Actively managed funds may carry initial purchase premiums of up to 5% (for load funds), or may have no purchase premiums at all (for no-load funds). Ongoing management fees usually range from 1% to 3%.
- Passively Managed (Index) Funds. Unlike actively managed mutual funds, index funds don’t engage dedicated investment managers and analysts. Instead, these funds mimic the performance of a particular index, commodity, or industry. Many index funds simply track major stock indices, such as the Dow Jones Industrial Average, S&P 500, or NASDAQ. Other index funds include a wide range of components – such as Fortune 500 financial institutions, energy and mining companies, and smaller biotechnology firms – that are representative of the entire stock market. Still other index funds are closely tied to the price of individual commodities, such as oil, wheat, or silver. And there are many index funds that focus on sectors of the equity market, such as emerging markets, growth, small cap, mid cap, large cap, technology, pharmaceutical, healthcare, materials, and finance stocks. Index funds’ management fees are usually lower than actively managed funds, often less than 1%.
There are two ways of differentiating how mutual funds are structured and traded.
- Open-End Funds. Early mutual funds were structured as open-end funds, and the arrangement remains popular. These instruments can be actively or passively managed, and they don’t have a fixed share count. Rather, overseers can create or retire shares in response to investor demand, reducing share price spikes during periods of high demand, and mitigating price drops when demand slips. Index funds are a type of open-end fund. An open-end fund always trades at net asset value (NAV), which is the ratio of the total value of all its components to the total number of shares in the fund. This figure is recalculated at the end of each trading day and remains in force throughout the following trading day, regardless of what happens to the market during trading hours. All open-end fund transactions occur at market close, so it doesn’t matter what time of day you put in your order. Unlike stock, ETF, and closed-end fund transactions, open-end fund transactions must occur between the buyer or seller and the fund’s manager – they can never be executed by an independent broker on the open markets.
- Closed-End Funds. Relative to open-end funds, closed-end funds (CEFs) have more in common with ETFs. Closed-end funds always have the same share count, regardless of demand. These instruments are listed on exchanges, such as the NYSE and NASDAQ, so you can always trade shares on the open market throughout the trading day. Each closed-end fund also has a NAV that’s recalculated at the end of each trading day, based on the actual value of its components at that time. Intra-day transactions are priced at a premium or discount to the previous day’s figure depending on what investors are willing to pay from minute to minute. A CEF’s intra-day trading price can be significantly discounted – often 90 to 95 cents on the dollar – relative to its NAV, depending on the composition of its holdings, the reputation of its managers, and the past performance of individual components. But while CEFs and ETFs share similarities, they’re not identical – CEFs are often actively managed, and they trade at steeper discounts or premiums to NAV than most ETFs.
What Is an ETF?
Like closed-end mutual funds and stocks, ETFs trade on regular stock exchanges and are created with specific objectives in mind. For instance, an ETF’s components may mirror the performance of a broader stock index, such as the S&P 500, or a commodity, such as lithium. Because ETFs are traded on the regular stock exchanges, their valuations change in real time over the course of a trading day, despite their underlying NAVs.
ETFs aren’t actively managed. Once an ETF is created, it operates with little intervention from its issuer – and as such, ETFs carry significantly lower fees than actively managed mutual funds.
Like index funds, ETFs can generate capital gains as a result of asset sales. The IRS requires all funds, including these index funds and ETFs, to distribute any accrued capital gains to shareholders on an annual basis. However, ETFs are often structured to minimize capital gains distributions.
Understanding the Differences
Since ETFs and open-end index funds are frequently cited as alternatives to one another, it’s important to understand the distinctions between them before choosing which one to purchase. Several of the most noteworthy differences include:
1. ETFs Don’t Need to Hold Cash
ETFs are bought and sold like stocks. When you want to sell an ETF, you simply place an order with your brokerage and wait until another investor buys it. You then receive cash from the investor who buys your shares, leaving the fund’s assets intact. By contrast, all sales (redemption requests) of an open-end index fund are facilitated by the fund’s manager. When you sell shares in these funds, you’re compensated with cash from the fund itself. To ensure that the fund has enough cash to honor each day’s redemption requests, its manager may have to set aside substantial reserves of cash.
When demand for index fund shares is high, such as when its underlying index is outperforming the broader market, having adequate cash to honor redemptions isn’t much of an issue. However, periods of market turmoil may result in more redemption requests than the fund can handle. This may force the manager to raise cash by selling attractive holdings, or to preserve cash by refraining from purchasing new holdings. With more of its capital allocated to cash, the fund could miss out on upswings in the underlying index, reducing its potential returns.
Also, an index fund’s expense ratio – the combined fees charged for management and operation – accrues on the entire amount that its customers invest, including cash balances held to cover redemptions. In effect, index funds with large, persistent cash reserves charge customers for the privilege of keeping their cash safe – which most banks don’t do. This hidden cost, known as cash drag, is a disadvantage for open-end index fund holders when compared to ETFs because ETFs don’t have to hold substantial liquid reserves.
2. ETFs Don’t Have Restrictive Purchase Minimums
Designed to mimic the trading flexibility of stocks, ETFs lack purchase minimums. You can buy an ETF on the open market in increments of one share, although this may be impractical given brokerage commissions. This is a big advantage over open-end index funds, which typically require a minimum investment of at least $1,000.
That said, open-end index funds’ purchase minimums may be lower when held in retirement accounts, such as IRAs. For instance, Vanguard requires a $3,000 minimum purchase for investments in its Investor Shares index funds, but the minimum purchase is reduced to $1,000 for investments held in IRAs.
3. ETFs Are More Liquid
No matter how many people want to buy or sell an open-end index fund during the trading day, the fund only changes value once: when its NAV is recalculated at the close of business each day. While ETFs also have a NAV that’s recalculated at the close of each trading day, an ETFs’ intra-day trading price enables traders to buy and sell with greater flexibility.
Heavily traded, highly liquid ETFs may change value many times per minute, creating a vibrant market for traders. For instance, if you place a buy order at 1pm for an ETF that’s trading at $100 per share, and there’s a seller ready to part with his or her shares, you can be confident that your order will fill promptly at that price.
4. Index Funds May Be Less Expensive
While ETFs and index funds both have lower expense ratios than actively managed mutual funds, index funds appear to be cheaper. Fees and expenses vary widely between funds, but a recent study by a Vanguard Group investment strategist found that ETFs and index funds have an average expense ratio of 0.3% and 0.15%, respectively. Additionally, many index funds are no-load, meaning they don’t carry upfront commission costs. Brokers typically charge commissions on ETF transactions.
Even if you prefer ETFs, the increasing number of low-cost index funds is a good thing because competition is driving costs down. Several well-known fund issuers, including Schwab and Vanguard, have dropped the expense ratios on popular ETFs to less than 0.1%.
5. ETFs May Have Less Tax Liability
Passively managed ETFs have an important tax advantage over open-end index funds. Since all open-end fund transactions occur between the investor and the fund manager, the manager must sell some of the fund’s assets when an investor wants to get rid of his or her shares. This action creates capital gains or losses. Because index fund investors own shares of the fund’s entire asset portfolio, if the assets are sold for more than their original purchase price, the transaction results in capital gains for all investors, not just the person cashing out his or her stake.
Over the course of a year, especially if there’s tumult in the market that encourages lots of investors to sell their holdings, these transactions can produce a significant capital gain. If the fund’s manager distributes this gain as cash to shareholders at the end of the year, they’re then responsible for the resulting tax liability, even if they didn’t buy or sell shares in the fund that year.
By contrast, ETF trades occur between individual investors on the open market. Fund managers don’t sell assets to raise cash for transactions, so they’re less likely to create capital gains liabilities that must be distributed to fund investors. When you sell your shares in an ETF, you’re still responsible for paying capital gains tax on your transaction, but you’re unlikely to be hit with a tax liability if you hold onto your fund’s shares.
6. ETFs’ Market Pricing and Liquidity Can Be Riskier
While you might appreciate buying and selling your ETFs at prices that reflect the real-time market environment, there is a downside. Because an ETF’s price isn’t directly tied to its NAV, ETFs are susceptible to manipulations that might not be agreeable to risk-averse investors who prefer stable assets, such as bonds.
For instance, ETFs and index funds offer access to bonds, but unlike open-end index funds, ETFs can be sold short. Advanced traders who believe bond prices will fall may open short positions in bond-focused ETFs, driving down the value of longer-term investors’ holdings or causing unpleasant price gyrations over short time-frames. Index funds generally offer more stability for conservative investors.
7. Open-End Index Fund Managers Streamline the Buying Process
Since the counter-party to an open-end index fund transaction is always the fund manager, you know you’ll always have a willing buyer or seller to do business with. Since ETFs trade on the open market directly to other investors, they might be harder to buy or sell. Additionally, open-end index fund transactions take just one day to settle, while it takes three days for ETF transactions. This gives former index fund holders faster access to cash following a sale.
Finally, many mutual fund management companies, including Vanguard and Barclays, offer dividend reinvestment programs (DRIPs) that automatically reinvest capital gains and dividend distributions for shareholders. While some ETF issuers offer DRIPs and capital gains reinvestment, most don’t make regular distributions, so they don’t offer these features.
ETFs and open-end index funds are similar in some ways; however, they also have many points of distinction. It’s important to set clear goals for your investments to effectively select the type of investment that works for you. For instance, if you want the flexibility of real-time pricing, or the tax advantages of long-term shareholding, ETFs may be the way to go.
On the other hand, ETFs are more susceptible to market volatility, which may be unattractive if you’re a conservative investor, or if you want to earn regular income without dealing with short-term price fluctuations. Although some bond-focused ETFs exist, index funds may be a better choice if you’re looking for exposure to illiquid asset classes, such as municipal and international bonds. In the end, your personal preference comes down to your need for liquidity, the amount you have to invest, your time horizon, and your preferred asset classes.
Have you invested in ETFs or open-end index funds?