Exchange-Traded Funds (ETFs) and Mutual Funds often get lumped into the same bucket of investment strategies and used interchangeably in conversations. They are both wildly popular, SEC-regulated fund structures that hold a group of securities, which allows investors to easily diversify portfolios. However, there are some key differences of which investors should be aware.
Open-ended mutual funds are investment companies that sell shares to investors. Each share represents an ownership slice of the fund and provides the investor a proportionate financial right to the investments owned by the fund and purchased by the fund’s portfolio manager(s) with the pooled cash from investors.
Mutual funds calculate their value per share each day after markets close. This net asset value (NAV) is reported back to custodians and investors to calculate market performance on a daily basis.
When an investor wishes to sell their mutual fund investment, shares are redeemed back to the mutual fund company at their NAV.
Like mutual funds, ETFs are registered with the SEC as investment companies under the Investment Company Act of 1940. However, investors do not purchase and redeem shares with the ETF company.
Instead, ETF sponsors enter into contracts with registered financial institutions to act as Authorized Participants (APs). APs create ETF shares in increments called creation units by purchasing and assembling securities at their appropriate weightings, then exchange those securities for ETF shares from the sponsor. The newly created ETF shares are traded on a national stock exchange at market prices like a publicly traded individual stock.
When an investor wishes to sell their ETF investment, the process is reversed with APs purchasing ETF shares on the market as redemption units and exchanging them with the sponsor for the underlying securities.
Initially, ETFs were specifically designed to track the performance of U.S. equity indexes, but today, there are large international stock ETFs, fixed income ETFs, and actively managed ETFs. The proliferation of investment products and strategies has made it difficult for investors to differentiate and identify best case uses.
- Intraday Pricing
Because ETF shares are purchased on publicly traded markets, they are subject to real-time intraday pricing and market movements, whereas mutual fund purchases and redemptions are based on the NAV at the close of each trading day. ETF intraday pricing can cause premiums and discounts between the market price and NAV, but APs aim to keep the market price closely aligned with the NAV.
- Market Order Types
An optional benefit of purchasing ETF shares on publicly traded markets is the availability of alternative types of market orders including limit orders, stop orders, and stop-limit orders. The rules-based or risk management type strategies that are typically utilized for individual stocks can be applied for ETFs.
- Share Classes & Transaction Costs
Mutual funds will typically have multiple share classes available for investors. There are numerous options for broker dealers with varying sales-related charges and expense ratios with embedded fees (e.g., front-end / back-end sales loads and 12b-1 fees).
For fee-only registered investment advisors, there are typically two options utilized: 1) an institutional share class with the lowest expense ratio and a nominal transaction fee, which could range from $20 to $75, or 2) an investor/no-load A share class with a higher expense ratio, but no transaction fee.
ETFs do not have multiple share classes, so the expense side is simple to navigate and compare. Because they are traded like an equity security, they are subject to the same equity transaction costs, which are now zero at most major third-party custodians.
Generally, ETFs are more tax efficient than mutual funds. ETF creation and redemption unit transactions are typically conducted as tax-deferred, in-kind transfers. Whereas mutual fund redemptions may cause the mutual fund to sell securities to pay out cash, then distribute out net capital gains (cap gain distributions) to all shareholders, not just the redeeming shareholder. And it’s not just redemptions; rebalancing or repositioning trades may result in the distribution of capital gains from mutual funds.
- Charitable Giving
Both appreciated mutual funds and ETFs held for more than one year can be donated to eligible charities for a charitable deduction, thereby allowing the owner to avoid recognizing any unrealized tax gain. However, mutual funds are generally transferred through a change of ownership on the issuer’s books, not through the automatic transfer system like an ETF. The charitable organization’s broker/custodial firm may have an issue accepting the transferred mutual fund as well, necessitating a new account. These potential issues should be kept in mind at year-end to ensure that you have the proper amount of time to address your charitable giving and tax planning.
Mutual funds are not required to report their security holdings until 60 days after the fiscal quarter ends, whereas most ETFs disclose their holding on a daily basis. (Note: There is a small subset of semi-transparent, active ETFs that received approval from the SEC starting in 2019 to report monthly or quarterly.)
- Cash Settlement
When a mutual fund is sold, net cash proceeds from the transaction are available for transfer on the following day. When an ETF is sold, similar to an individual stock, net cash proceeds from the transaction is available for transfer two days after the transaction.
Please consider consulting an investment advisor to determine what investment vehicle works best for your accounts and your situation. Our goal at RBG Wealth Advisors is to compound investment portfolios to meet financial planning needs. We also want to make sure that we do it in the most efficient way possible while preserving strategic features.
Sources: State Street Global Advisors, FINRA