ETFs vs Mutual Funds

ETFs Aug 31, 2021 / Reading Time: 6 mins
ETF vs Mutual Funds
By Raymond Zhou Reading Time: 6 mins

When I ask you “what is a fund?”, what comes to mind? Perhaps it is an investor’s aggregated wealth? Or it might be money set aside for a new road by the government. Some may think of their superannuation funds. These responses would all be correct. A fund is indeed a pool of money that is allocated for a specific purpose and invested into a range of securities.  

But what if I told you that there were funds that we could invest into like a stock. Often mistakenly used interchangeably, mutual funds and ETFs are opportunities for investors to put some of their money into large funds. Beyond having similar names, there are indeed many similarities between the two funds. However, there are key traits that differentiate ETFs and Mutual Funds from one another. Maqro is here to help you dissect these funds and choose what’s best for you.

What is a Mutual Fund?

Mutual funds pool together the money from investors and are actively buying or selling assets within the fund. They attempt to outperform the market and help investors profit. These funds come in two types: open-ended and close-ended.

For open-ended funds, trading is conducted between investors and the fund with the number of shares outstanding being limitless. Prices would be determined by net asset value (NAV) and reflect changes to the value of the fund’s portfolio. Net asset value alludes to the underlying value of securities held by that fund. The value of the individual share is not affected by the number of shares outstanding.

Meanwhile, close-ended funds issue a fixed amount of shares, regardless of investor demand. Thus, it is this demand, not the NAV of the fund that determines the price of a share. In both cases, investors buy shares of the mutual fund directly from the company- and these are not traded on public exchanges.

Some mutual fund providers include Vanguard or Fidelity.

What is an ETF?

ETFs are mostly passively managed, as they typically track a specific market index. They can be bought and sold like stocks.

ETFs may commonly track a market index or commodity, and are classified as “index funds”. The performance of the ETF is correlated to the performance of the underlying index. Lately, there has been a growing number of actively managed ETFs, where these managers attempt to outperform a benchmark index by tailoring their stock picks to specific objectives. Because ETFs are continually traded on the market, there is the potential for arbitrage to take place as market prices may not correspond to its NAV.

The ETF market in Australia is currently worth approximately $102bn with popular providers such as Betashares, BlackRock (via iShares), Vanguard, and VanEck all having listed ETFs on the ASX for investors to trade.

A diagram to show the similarities of an ETF with a stock and managed fund. ETFs are a diversified, low-cost way to invest.

What are the upsides?

The major upside of mutual funds and ETFs is the ability to add diversity to one’s portfolio effectively and affordably. Both mutual funds and ETFs pool together money from investors, then invest this money into a basket of stocks, bonds, and other securities.

We don’t have to go out and buy say, 75 different stocks on our own. We can achieve this diversification if we buy shares in an ETF that tracks 75 stocks e.g. VanEck Vectors Australian Equal Weight; we are effectively holding 75 stocks ourselves with that one stock.

You can quickly begin to see how this is also very cost-effective. Sticking with our previous example, because 1 share is effectively equivalent to 75 companies, our single transaction means that we do not have to execute 75 trades, and thus lowering our cost of investing.

Moreover, with mutual funds being actively managed, investing in these funds is an affordable way to introduce an active investing element in our portfolio, while we can remain passive about our portfolio as a whole. ETFs on the other hand generally have lower fees due to their passive investing nature. However, there is no consensus as to whether passive fund returns exceed active funds.

Nowadays, there is a range of mutual funds and ETFs that cater to specific risk appetites and investing objectives. Want downside protection in your portfolio?. There are inverse ETFs such as the BetaShares Australian Equities Bear Hedge Fund (BEAR.ASX). Or perhaps you want to invest in bonds? Vanguard’s Long-Term Corporate Bond Index fund is an option. There are a plethora of funds with opportunities in international equities, international bonds, commodities, there has even been speculation surrounding a crypto ETF.

In fact, the universe of funds is increasing in Australia with over $4.1tn funds under management. There are over 200 ETFs traded on the ASX. Whereas 131 registered fund managers operate over 200 mutual funds to invest in. Mutual Funds and ETFs allow us to better customise our portfolios and exposes our portfolio to assets that were previously inaccessible for us.

Let’s compare

Similarities

Beyond sharing similar names, both mutual funds and ETFs pool money from investors to invest in a basket of assets. Both fund types may even be investing in the same assets or employ the same investing strategies. Compared to traditional forms of investing, both assets are thought of as low cost- with low fees and commissions.

The general principle of capital gains still applies to funds. Even though the upsides seem to be the same between the two, their differences have significant implications for investors.

Differences

The first point of difference comes from its price due to how these products are sold.

Since ETFs are traded on the stock exchange, market forces dictate the value of the fund itself. A well-performing ETF may attract more demand, leading to its price surpassing its NAV. Conversely, if there is a sudden sell-off of the fund’s shares, it could drop below NAV.

There are two outcomes of this. Firstly, if the underlying securities in the fund are doing well, but a manager at the ETF provider receives poor publicity, then this is likely to impact the ETF’s price despite the assets themselves performing well. Secondly, there are opportunities for arbitrage if the ETF’s price is lower than its NAV, whereas you may be overpaying for a fund when the ETF price exceeds its NAV. Thus ETFs are considered more liquid assets but also bears a degree of the direct market risk that is attributable to investor behaviour.

Mutual funds on the other hand are priced at their NAV at the close of every trading day. This means that prices of the fund shares directly correlate to how their underlying assets are performing. Instead, demand for the fund’s shares may be determined by how the managers perform or the reputation of the firms themselves.

ETFs are generally more tax-efficient than mutual funds because ETFs shares are traded on an exchange instead of redeemed with the fund company. If there are massive sell-offs of mutual shares funds, then the funds themselves may sell shares of the underlying securities resulting in capital gains tax implications for all shareholders, regardless of whether they sell.

Dividends from mutual funds can be reinvested by just checking a box but reinvesting ETF dividends will depend on whether the brokers offer this option. It should be noted that not all ETFs and mutual funds pay dividends and you must assess whether dividends are something you want in your portfolio.

Which one is the right fit for you?

Let’s entertain some scenarios to help you determine which is a more suitable vehicle to invest in.

If you prefer lower investment minimums…

  • Then an ETF might be more suitable for you because you can just purchase the ETF at its market price. There is no minimum amount of ETFs that you need to purchase (unless your broker has minimum restrictions).
  • A mutual may not be a suitable investment because the initial investment is not based on the fund’s share price. They are instead a flat dollar amount which includes fees and set-up costs. For example, most Vanguard funds have a $3,000 minimum, meaning that we would be buying 30 shares of a fund with a NAV of $100 per share.

If you want more control over your transaction price…

  • Again, an ETF might be the better option here. Because we trade on open markets, we can use different order types and either purchase at the market price or set the price at which we want to trade at.
  • A mutual would be less appealing because you will trade your shares at the same price as everyone else who traded their shares on that day.

If you want a more active component in your portfolio…

  • You should consider purchasing mutual fund shares. This is because mutual funds are actively managed by managers, who consistently monitor the fund’s performance
  • Although there are ETFs that are actively managed, they are scarce and require some investigating to uncover.
  • It is critical to keep in mind that active management does not always result in outperformance.

If you are looking for an index fund

  • An ETF could be a plausible option as most ETFs track indices or are indexed against the performance of an underlying asset.
  • However, mutual funds are also suitable as they may also base their performance on the performance of an index.

If you want automatically repeating transactions

  • Unfortunately, you cannot make automatic investments or withdrawals with ETFs and thus they are not a great option here.
  • Because you can set up automatic investments and withdrawals, mutual funds are a more suitable option.

In summary

So despite sharing similar-sounding names, we can see how ETFs and Mutual Funds are distinct from one another. There are different characteristics of each fund that make it suitable for different risk appetites and investment objectives. Funds are another asset in the investment multiverse that is worth considering for any budding investor.