While the mutual fund industry is much larger and older than the fledgling Exchange Traded Fund (ETF) industry, the size and scope of ETFs are growing at a rapid rate as ETFs become a popular investment choice for many investors. The mutual fund market manages over $12.5 trillion in assets across 7,500 funds, compared to just over $1.1 trillion in roughly 1,000 ETFs; however, there are some important differences between ETFs and mutual funds that investors should understand, particularly with regards to trading conventions, costs, and taxes.
One of the largest differences between mutual funds and ETFs is the way transactions are structured. Shares of a mutual fund are not listed publicly, so an investor can work directly with the mutual fund company to purchase and redeem shares. When an investor purchases shares, new shares of the fund are created; when an investor redeems his shares, the shares are removed from circulation and the number of shares decreases. However, there is a fixed number of shares of an ETF, and these shares trade freely on the exchanges, meaning that you must buy and sell them on the markets through a broker.
This difference in trading conventions causes a difference in the investment costs. For most no-load mutual fund, you will purchase or redeem the mutual fund without having to pay any type of sales or trading commission—you only have to pay an annual fee. By contrast, you must pay a trading fee every time you buy or sell an ETF to compensate the broker (just like stock trades). If you plan on investing a small amount per month, your ETF transaction fees will add up quickly and give mutual funds the advantage. However, ETFs typically have much lower annual expense ratios; even compared to the ultra-low fee Vanguard 500 Index fund (VFINX) with expenses of only 0.17% per year, the SPDR S&P 500 Fund (SPY) only charges 0.09% per year.
Another implication of different trading conventions is different tax treatments. Whenever a mutual fund realizes a capital gain, the investor must pay taxes on the gains even if they never redeem their shares and they simply reinvest the gains. However, since ETFs are bought and sold on the open market, you are not liable to pay taxes until you actually sell your shares, regardless of the activity in the portfolio. Because of this design, ETFs are typically more tax-efficient than most mutual funds, but you must be sure to take into account your personal tax situation before assuming one type of investment is automatically better than another.
While mutual funds and ETFs both have a place in an investor’s portfolio, the distinctions of trading conventions, costs, and taxes may help you decide which investment vehicle you should choose when considering between the two.