Open-end mutual funds and exchange traded funds (ETFs) are the two most common ways to invest in passive index funds. How are they similar in investment characteristics? How do they differ for investors?
All that and more in Episode 41 on the Wilson Wealth Management YouTube channel.
“What are trading considerations with ETFs and mutual funds?”
ETFs trade on public exchanges. You can buy or sell at any time in the trading day. Open-end mutual funds, as opposed to closed-end funds which we will not include in this discussion, are bought and sold directly with the fund company. With the majority of funds, being tradable at close of day net asset value.
If you are an active trader, who wants to jump in and out of investments, the ability to continuously trade may make ETFs more attractive. For most long-term investors though, this is not an issue.
“What about liquidity?”
ETFs can be traded continuously, whereas mutual funds can only be liquidated in set time periods. Often, end of day valuations. But in some funds, less frequently.
So ETFs are more liquid.
Or not.
If you own an ETF that is thinly traded or has little market capitalization, it may be difficult to find a buyer or seller to trade with. The harder it is, the greater the bid-ask price spreads, which impact asset liquidity.
Whereas, unless your fund company is insolvent, you always have a ready partner to buy or sell mutual fund units.
It is prudent to invest in ETFs with significant assets under instrument, that trade on established stock exchanges. With mutual funds, consider fund companies that are well established, with strong finances.
For a little more on trading and liquidity, please refer to “ETFs versus Funds: Trading Advantages”.
“What about transaction costs? Sales commissions, brokerage fees, and so on?”
ETFs are traded on stock exchanges. Usually there will be a brokerage commission charged on each trade. Today, that may be under $10 per transaction, regardless of the volume. Of course, that is through an online broker, not a full-service one. So shop around when deciding on the brokerage house to use.
Some brokers offer certain “no-transaction fee” ETFs, where the trading costs are waived. Not an extensive list. Often not “best of class” ETFs. But something to consider when weighing which ETF to purchase.
Mutual funds do not incur brokerage fees. But you may be charged a sales commission, or load, when buying or selling a fund.
Research data indicates that sales commission funds do not provide superior performance over no-load funds. And that is definitely true for simple, index funds. Unless you plan to invest in some extreme-niche index, never pay a load for an index fund.
“Taxes are another cost. How do ETFs and mutual funds compare on tax efficiency?”
Tax treatment varies on a jurisdiction by jurisdiction basis.
Often, ETFs offer better tax efficiency. But investors should consider their own tax jurisdiction and personal situation. Then factor that into the cost analysis.
For a little more on transaction costs and taxes, please read “ETFs versus Funds: Transaction Costs”.
“What about Management Expense Ratios (MERs) differences in mutual funds and ETFs?”
ETFs, on average and over time, have enjoyed lower MERs.
But that can be a tad misleading. Historically, mutual funds tended to be actively managed. ETFs were more passive. One would expect a cost gap given the lack of management fees in the passive ETFs.
But even comparing apples to apples, ETFs still tend to maintain a cost advantage. Not always. And there are other factors that come into play. Economies of scale being the big one.
Do not automatically assume that ETFs will be less expensive. Within an asset class or subclass, assess across all passive investments in comparing net performance and cost structure.
If you wish to read more, please refer to “ETFs versus Funds: Expense Ratios”.
