Heard of Exchange Traded Funds (ETFs) but not actually sure how they differ from other mutual funds? Don’t worry, you’re not alone. Whilst they both focus on tracking an index fund, it’s how they can be bought and sold which makes them distinct from one another.
So, what is the difference between ETFs and all the other funds out there?
ETFs vs Mutual Fund: Key differences
ETFs and mutual funds carry the same characteristics of enabling investors to invest in a variety of different assets (stocks, bonds and commodities) through the channel of a single fund.
The main distinction between ETFs and other mutual funds is how often, and when, they can be bought and sold. Whilst mutual funds can only be traded at the end of the day, ETFs can be bought at any time during the clock. What’s more, while mutual funds have to be bought through a particular fund company, ETFs can be bought on the open stock exchange.
Another key difference is that while most mutual funds have (until recently) been actively managed – i.e. managed by an expert who picks and chooses investments in an attempt to beat the market – ETFs are passively managed.
That means they track certain market indexes with an attempt to mimic, rather than beat, the market. But this distinction has been less cut and dry in recent years, as passive index funds make up a significant proportion of mutual funds' assets under management, while there is a growing range of actively-managed ETFs available to investors.
Other key differences
Humans and algorithms
First and foremost, ETFs are passively managed funds. This means that there is usually an algorithm that is tracking a market index which dictates the stocks held in the ETF fund. There is no human input, no team of analysts trying to select greater or smaller quantities of high performing stocks, it is simply a replica of a market index.
If there is a team of people managing a fund, trying to actively outperform market indices, it is generally known as an actively managed fund. Humans, and knowledge, come with a price. Actively managed funds generally carry higher entry, ongoing and potentially even performance related fees. ETFs on the other hand can benefit from the relative lack of labour and are therefore generally cheaper than actively managed funds.
An ETF’s performance will be directly linked to that of the market that it is tracking. Other funds follow a theme, which can be a huge range of areas from geography, sector, commodity, risk level or investment approach. If markets are up, it figures that so will your ETF. If markets are down or stagnant, you guessed it, so will the ETF.
Actively managed funds may well outperform ETFs in times of down markets, at the end of the day, that is their job. However, actively managed funds come with no guarantees and are subject to the stock picking technique, lucky stars, experience, and even sheer confidence of the fund manager. It’s not always the case that they outperform markets.
ETFs come out on top when it comes to cost efficiency
The most common ETFs will track global market indices, such as the S&P 500 in the US or the FTSE 100 in the UK. As the appetite for ETFs has grown, there are also green, ESG and gender equality ETFs available. As they’re tracking a diverse blend of stocks, made up of potentially lots of different sectors, they’re less susceptible to company and sector shocks.
As larger markets generally weather shocks a little bit better, the value of ETFs can be less volatile than sector or geography specific active funds. You’ll generally have a broader knowledge of market performance and don’t need to be tapping into accounting figures and CEO scandals as often. ETFs can therefore be a little lower maintenance than actively managed funds which can be a bit needier with their attention.
Unfortunately, mutual funds make taxable year-end distributions. On the other hand, ETFs do not. That’s because ETFs track a certain index and do not involve taxable distribution. ETFs are therefore more tax efficient as you will only owe taxes based on the profits and losses of your individual trades.
In general, ETFs come out on top when it comes to cost efficiency. Mutual funds have a lot of costs tied to them, such as transaction fees, distribution charges, and transfer-agent costs. They’ll even send over an annual tax bill on any capital gains earned. That means that returns made on a mutual fund are quickly overridden by hefty fees, and can undermine your investing goals entirely.
Meanwhile, ETFs offer more trading flexibility as they’re bought and sold openly on the stock exchange. They have fees attached to them, and are more tax efficient than mutual funds, overall making them a cheaper alternative.
Should I invest in an ETF or a mutual fund?
Since ETFs are openly traded on the stock exchange 24 hours a day, this makes ETFs a more liquid option compared to mutual funds. So if trading ETFs like a stock is a priority for you, then an ETF would be the way to go.
Which are riskier: ETFs or mutual funds?
From a general perspective, there is no stand out characteristic that makes either an ETF or mutual fund more risky than another. It will always come down to the fund’s allocation of assets that will determine whether a particular fund is more risky than an ETF. It’s therefore essential you do your due diligence before investing in an ETF or mutual fund.
Do ETFS and mutual funds pay dividends?
Many mutual funds and ETFs pay out dividends, but not all of them and will depend on whether it holds stock which chooses to distribute dividends with shareholders.