There has been a lot of talk recently about how it is best for individual investors to invest in Exchange Traded Funds (ETFs) vs. Mutual Funds. Although some of the rationale is strong, you need to know in what you are actually investing. Let’s start with the basics.
What is an ETF?
Exchange Traded Funds (EFTs) is an investment that pools money from investors and uses those funds to buy a basket of stocks, bonds or other securities. You purchase a share of an ETF just as you would purchase a share of a stock. ETFs typically track a market index or commodity, although actively managed ETFs are becoming more popular. An active fund manager tries to outperform an index by being more selective in the investments it owns.
What is a Mutual Fund?
A mutual fund is an investment that pools money from investors and uses those funds to buy a basket of stocks, bonds or other securities. You purchase a mutual fund directly from the fund company. The manager of the fund and their analysts try to pick the best investments available rather that a set group of stocks or bonds.
Similarities and Differences
- Pricing: The pricing difference can be significant. Mutual funds are priced once a day after the market closes and the value of the stocks at the end of the day. ETFs are traded while the market is open similar to stocks. The value of the EFT is determined by the bid and ask price, i.e., the price at which someone would pay for a share of that ETF vs. the price at which someone would sell that ETF. If the market is volatile the difference between the bid and ask price could be significant.
- Expense Ratio: The internal costs or operating expenses of the fund expressed as a percentage of the funds value is the expense ratio. This includes portfolio management, trading expenses, marketing, administrative and distribution expenses among others. Although in the past it was typical for an ETF to have a lower expense ratio than a Mutual Fund, this trend, although still exists, is narrowing. Mutual Funds are reducing expense ratios to be more competitive and as actively managed ETFs are becoming more popular some ETF expense ratios are increasing.
- Holdings: I believe that what is actually held by a Mutual Fund or ETF can be the most important aspect of the fund. Unfortunately, this research, although readily available, is not typically performed by purchasers. Here are a couple of examples:
- two seemingly identical Standard & Poor’s 500 stock index (a large company index) ETFs have very dissimilar returns. That is because one purchases the same number of shares of each stock in the index, while the other purchase an equal dollar amount of each stock in the index.
- I was just looking up a tech company in the Netherlands. It was a large company stock that had been over valued (the value of the stock vs. its price) by Morningstar (a rating company) for the last 4 years. I then looked at the funds that had the largest holdings in this stock. The top three funds were a low-priced stock Mutual Fund, a Standard & Poor’s 500 Index, and a mid-cap stock index. By looking at the titles of these funds this stock, a member of the Standard & Poor’s 500, only should have been in the Standard & Poor’s 500 Index. The stock is not a low-priced stock nor is it a mid-cap stock.
The point of this is that you are responsible to know what you are purchasing and to make sure you are investing in what you are thinking you are. Look at how much it is costing you to invest in the fund and that when you choose to buy or sell you are getting a fair price. You would not purchase a car without doing your research and looking under the hood, do the same with your investments.