DIY investing is everywhere, and there are more ways to invest now than at any point in our collective history. But in my life as a Financial Advisor, I observe many individual investors are still confused about the different investment vehicles available.
In my ongoing quest to make you a better investor, I’m offering a tutorial this month on two of the most well-known- yet poorly understood investment vehicles available – mutual funds and exchange-traded funds.
Structure of Mutual Funds & ETFs
While it may not feel intuitive, the core differences between mutual funds and exchange traded funds (ETFs, for short) relate to how they are formed, owned, bought, and sold.
You might ask yourself, “What is a mutual fund?”. A mutual fund is a vehicle formed by an investment company that pools the dollars of individual investors (hence the term “mutual”) to buy securities to meet specific investment objectives. It is important to understand that a mutual fund is its own entity.
Although “shares” is often applied to mutual funds, what you own are “units.” Those units represent your ownership in the mutual fund, and the investment company chooses and manages the securities held in the fund on behalf of unit owners.
With “index-based” mutual funds, the goal is to provide efficient exposure to the type of asset, industry, or sector of the economy. “Actively managed” mutual funds strive to outperform given indexes and/or benchmarks while managing risk and return efficiently.
An exchange traded fund (ETF) is similar to a mutual fund in some respects. For example, an ETF is also created by an entity, often a large financial institution.
But the mechanics of ownership and trading differ greatly. Put simply, an ETF is created when the large financial institution buys shares of various securities on the open market, packages that basket of securities into shares, and then makes the shares of the basket (i.e., ETF) available for trading on the open market.
ETF shares are typically designed to replicate or mirror the performance of a given benchmark or index.
Buying & Selling Mutual Funds & ETFs
As the name implies, Exchange Traded Funds trade on an exchange, much like stocks.
That means you can buy or sell shares of an ETF at any time during the trading day, 8:30 AM to 3:00 PM Central Time. That also means the price of an ETF share will fluctuate throughout the day. Blackrock, a popular ETF creator, estimates that over 8,000 ETFs are trading daily on stock markets globally.
For example, one share of SPDR S&P 500 ETF Trust (SPY) traded at $411.49 when the market opened on April 28, 2023. When the market closed, the price was $415.93. During the day, the highest price was $415.94, and the lowest price was $411.43. Shares of this ETF could have been purchased and/or sold by an investor at any time during the trading day.
Mutual Funds do not trade on an exchange. In fact, mutual fund units are bought directly from – and sold directly back to – the investment company that manages the mutual fund. More specifically, mutual fund units are purchased and redeemed rather than traded on any exchange. Further, mutual fund units price just once per day.
Let’s look at Vanguard 500 Index Fund (VFIAX) for comparison.
When the stock market opened on April 28, 2023, a share of VFIAX was valued at $381.78 (equal to the prior day’s price). When the stock market closed, a share was worth $384.97.
There was no high or low because mutual funds price once daily after the market closes. If an investor had wished to sell (redeem) their shares and entered an order to that effect at 9:00 am, that order would price and execute after the market closed at 3:00 pm.
Valuing Mutual Funds and ETFs
The value of a mutual fund unit is simply the value of the underlying securities held by the investment company divided by the number of outstanding mutual fund units. The unit price is called the Net Asset Value (NAV).
If you request to buy units, the investment company goes out into the market and purchases more of the fund’s underlying securities to create new units, which subsequently appear in your account. The opposite occurs when you redeem units. This is why units are only priced once a day.
As for ETFs, because they trade on an exchange, the value of an ETF share can and will fluctuate based on the value of the underlying assets and the immediate supply and demand for shares of that ETF. This is an important distinction between mutual funds and ETFs.
In a perfect world, the prices of the securities held in the ETF basket would immediately and directly translate to the ETF share price all the time. There is a mechanism to bring share prices in line with the value of the underlying assets.
However, the fact that demand for an ETF share could result in the share price being greater or lesser than the value of the underlying basket of stocks it represents is a risk that investors must be aware of when selecting which ETFs to own. This is called a tracking error.
One of the biggest differences between the typical ETF and typical mutual fund is their associated internal expenses.
Both of these types of vehicles have to be created and administered. That creation and administration cost something. That something is paid for through internal expenses.
Typically, mutual funds have higher internal expenses than ETFs. This isn’t always true, but it is often true.
The average mutual fund has an expense ratio of between 0.5% and 1.0%. The average ETF carries an expense ratio of 0.2%.
Learn More: In Praise of Simplicity
Why the difference?
Mutual Funds are often actively managed. That means a team of people work, day in and day out to select the right set of securities that they believe will best meet the fund’s investment objective. Those people earn a salary and perform the research needed to be effective in their work, and that endeavor costs money.
Not to mention, the investment company requires support staff, office space, marketing, and other overhead in order to exist as a business.
In contrast, ETFs are often passively managed and do not always require a large team of people drawing a salary or producing research - it typically costs less to run such a vehicle.
And now we come to taxes. Another big difference is the tax consequences of owning one or the other of these two investment vehicles.
Remember back to the Structure section? A mutual fund is its own entity.
Normally, taxes are levied at the entity level. Not so with mutual funds, as they are considered a pass-through entity. That means that the consequences of any taxable activity that took place during the year must be passed through to the individual unit holders.
Although a unit holder has their own cost basis related to their own purchase and sale of the mutual fund unit, the cost basis of the underlying securities held in the mutual fund is shared by all unit holders, as is the investment income.
For example, let’s say that the BlackRock Global Allocation Fund (MDLOX) management team bought 1,000 shares of XYZ Corp. (XYZ) for $100 a share on January 1, 2021. They held those shares until January 2, 2022, and then sold them for $110 a share.
If they were taxed at the entity level, BlackRock Global Allocation Fund could owe a tax liability of $2,000 for that trading activity. Instead, they will distribute the capital gain, on a pro-rata basis, to each unit holder, who will then pay taxes on their portion of the gain.
This arrangement has some important implications for investors.
Lack of control
As a unit holder in a mutual fund, you will have no control over the gains (or losses) realized inside the mutual funds you own. That means you might be handed an unexpected (and unwelcome) capital gain at year end-, even if the unit price of the mutual fund is lower than the unit price on the date on which it was purchased. How could this happen?
Capital gains distributions
Imagine that our friends at BlackRock Global Allocation Fund (MDLOX) made a long-term trade back in 2013. They saw that ABC Corp. (ABC) shares were grossly undervalued, and they bought 1,000 shares for $5 per share.
Over time, the stock price rose gradually until it reached $100 per share in 2021.
Also, in 2021, you purchased BlackRock Global Allocation fund shares. As a new unit holder, you haven’t really benefited from BlackRock’s 2013 bet on ABC Corp.
Suppose that in 2022, the management team at BlackRock decides to sell the shares for $100 per share, realizing a $95 per share gain. The resulting $95,000 gain is distributed to the current unit holders on a pro-rata basis.
Because you were a shareholder when the gain was realized, you are on the hook for your portion of the gain on ABC Corp. even though you didn’t really benefit from the gain in ABC.
When you buy an ETF, you aren’t buying a share of an investment company but rather a security the company created. What may seem like a small distinction but actually results in no pass-through tax liability to worry about. You avoid the capital gains distribution problem when you own exchange traded funds.
It’s important to note that with mutual funds and ETFs, you will trigger capital gains taxes if you buy shares and later sell them for a profit. However, you have some control over the timing of this taxable event.
Learn More: When Do My Investments Get Taxed?
Mutual Funds & ETFs TLDR
If your eyes glazed over after the first paragraph and you’ve skimmed down to the bottom, here’s a summary:
Unit holder owns part of an investment company
Shareholder owns a security created by a financial institution
Buying & Selling
Units are bought/redeemed directly from the investment company and are priced and traded once daily.
Shares bought/sold on an exchange. Priced and traded throughout the trading day.
Net Asset Value is determined at each day’s market close
Price based on Net Asset Value & market forces of supply/demand
Generally higher internal expenses
Generally lower internal expenses
Generally less tax efficient
Generally more tax efficient
So, which do I recommend? Either both or neither.
Like most investment vehicles, each of these tools has a time and a place where they are most useful. Without knowing your circumstances, needs, preferences, experience, etc., it’s impossible and irresponsible for me to recommend one over the other.
If you’re wondering if your investments really suit you, email me to request a portfolio review.
Investors should consider the investment objectives, risks, charges and expenses of each fund carefully before investing. This and other information is found in the prospectus and summary prospectus. For a prospectus or summary prospectus, contact your financial advisor. Please read the prospectus or summary prospectus carefully before investing.
 This is most likely to happen with ETFs that own exotic, complex, thinly traded, or difficult to value securities.