I’m sure you have heard about mutual funds. Mutual funds have been around as an investment vehicle in the US since 1924. However, have you also heard of another popular investment vehicle, the Exchange Traded Fund (ETF)? ETFs have been around since 1993 and have been gaining in in popularity ever since. But what’s the difference? And what exactly are mutual funds and ETFs? In this week’s blog I go into the difference.
First, let’s take a look at mutual funds.
Officially, mutual funds are an investment company, and they are regulated by the SEC Investment Company Act of 1940. As an investor, you purchase shares of the mutual fund itself. The mutual fund has a fund manager(s) that buy and sells securities (stocks and bonds for example) to achieve the mutual fund’s investment objective. An investment objective of a mutual fund might be growth for example. Therefore, if a mutual fund has a growth investment objective the fund manager may be buying and selling stocks to achieve the objective of growth for the mutual fund shareholders. As a mutual fund shareholder you own shares of the mutual fund itself, you do not own the individual stocks or bonds within the mutual fund.
Since mutual funds have a fund manager(s) that is buying and selling investments to achieve an investment objective they are considered an active type of investment. Moreover, since there is active trading going on inside the mutual fund, they tend to create capital gains throughout the year. These capital gains are then passed on to shareholders of the mutual fund. These are called capital gain distributions and they must be reported on your tax return in the year they are received regardless of if you take them as a cash or reinvest them. Also, you receive these capital gain distributions and must report them on your tax return regardless of if you sold shares of the mutual fund and took money out or not. For this reason, mutual funds are considered less tax efficient than ETFs (more on that a little later).
Lastly, mutual funds are an easy way to get diversification. When you buy shares of a mutual fund that mutual fund will likely be investing in many different companies and/or bonds and therefore when you purchase shares of a mutual fund you get diversification without having to go buy each individual investment on you own.
Now let’s look at ETFs.
ETFs are typically considered a passive investment because they typically track an underlying index. There is no fund manager buying or selling investments to meet an investment objective. Whatever investments compose the underlying index that the ETF is tracking are the investments that will make up the ETF. For example, if you are looking at an S&P 500 index ETF, that ETF will track the S&P 500 index and its associated holdings.
Since ETFs are considered passive investments with no fund manager buying and selling, they typically do not distribute capital gains to the shareholders throughout the year. This makes ETFs more tax efficient compared to mutual funds, especially when considering holding them in a taxable account. The passive nature of ETFs also generally means that their internal expense ratios are less than mutual funds.
Finally, ETFs are also an easy way to get diversification for your investment portfolio. Since you are buying shares of the ETF that track an underlying index and an underlying index will be made up of potentially hundreds of securities, when you buy shares of the ETF you will be getting exposure to the securities within the index without having to buy each security individually on your own.
There are some of the basics with mutual funds and ETFs. As always, if you have questions about how mutual funds and ETFs may fit into your retirement plan and investment portfolio please reach out to you financial planner or financial advisor.
Investing in mutual funds involves risk, including possible loss of principal. Fund value will fluctuate with market conditions and it may not achieve its investment objective.
ETFs trade like stocks, are subject to investment risk, fluctuate in market value, and may trade at prices above or below the ETF's net asset value (NAV). Upon redemption, the value of fund shares may be worth more or less than their original cost. ETFs carry additional risks such as not being diversified, possible trading halts, and index tracking errors.