ETF or Mutual Fund – What’s The Difference?
The Financialist • Issue 120 • January 2014
BY ALAIN QUENNEC BComm CFP FMA CIM
Most investors leave the choice of selection of individual stocks and bonds to a dedicated professional team whose full-time efforts are dedicated to that task. Investors pool their assets with each other to form a fund which has professional management.
Funds come mainly in two forms – ETFs (Exchange Traded Funds) and Mutual Funds. Neither is inherently better or worse than the other; however, they are different in many ways and those differences can be useful to the investor, depending on her own personal situation.
How They Are Purchased
ETFs are traded on the stock exchange, hence their name. They are most often traded throughout the day.
Most mutual funds are purchased and sold as of the end of each business day, after prices have been calculated, based on the closing price of each security within the fund.
You don’t know the exact purchase price of the mutual fund until after the close of business, but you can set the precise dollar amount you’ll invest, as you can buy partial units, whereas an ETF is purchased like a stock – you buy a set number of units at a set price.
A fund is a fund is a fund, whether ETF or mutual, and it can come in a variety of risk levels. You can have money market funds of the highest security, and you can have small mining companies from emerging economies that represent high risk.
It is not the fact that the stocks or bonds come in a fund “wrapper” that makes them risky or not – it is the underlying investments themselves.
Structural and Tax Features
Many mutual funds are available in “corporate class” versions that offer special tax benefits when held in non-registered accounts. The investor can have their capital gains negated by previous or ongoing capital losses in an “umbrella” company or other fund. The investor enjoys the growth, but without the tax burden, or some portion of it.
ETFs do not come in this form, and all capital gains, dividends, and interest are taxable either to the ETF itself or passed along to the investor when held in nonregistered accounts.
Because ETFs are most often based on mimicking an index, there is usually less trading, and so less generation of capital gains/losses year by year.
Mutual funds are most often managed “actively” – that is to say that there is a management team that uses not only financial analysis to determine which investments are most appropriate for their fund given their risk/return characteristics, but also their own professional judgement, gained from experience.
ETFs are mostly managed “passively” – that is to say the basket of securities is reflective of an index, like the Dow, or the S&P/TSX here in Canada. The ETF most often proportionally buys the securities that represent the index in order to replicate the performance of that index. Because perfection is impossible, the difference in performance between the ETF and its underlying index is called “tracking error”.
In some cases, an ETF can offer active management, although these cases are currently rare.
In either case, the mutual fund or ETF provides the investor with an opportunity to obtain great diversification at a very low cost, as each structure will have anywhere from several dozen to potentially thousands of securities within it. For the individual investor to replicate this basket of securities would be very expensive and largely impossible from a practical standpoint, without having an extremely large account.
Cost and Benefit
As with everything in life, these products come at a cost. They also provide a benefit. The relationship between cost and benefit is called value. We each decide differently what the value is, based on our own judgement and criteria.
That having been said, ETFs are generally less expensive than mutual funds. This is, in large part, because they do not usually offer the active management teams of managers and analysts. ETFs most often mimic some index or scientific criteria, requiring less management costs.
In general, equity funds are more expensive than fixed income funds, and foreign funds are more expensive than Canadian funds.
There is no absolute right and wrong when choosing between an ETF and mutual fund. There are many more complexities than outlined here, and some may be more relevant than others. As always, it is not information alone that will help us decide, but knowledge – the analysis and understanding of information in the context of each individual’s situation, and that’s where your Rogers Group Financial advisor serves you best.