Basics of Mutual Funds & ETFs

What are the Primary differences between Mutual Funds & ETFs?

There are many similarities between Mutual Funds & ETFs:

• Both Mutual Funds & ETFs are managed by investment professionals that are registered with the SEC.
• These products offer a wide degree of diversification which helps limit the risk of being overweighted in particular sectors of the economy.
• Both products allow for low minimum levels of investor investment.
• Both products allow the investor to liquidate their investment rather quickly.
• Both Mutual Funds and ETF will charge management fees regardless of their respective overall investment performance.
• Upon investing in Mutual Funds or ETFs, the investor cannot influence the investment strategy of the portfolio manager (i.e. lack of control).
• The underlying price of Mutual Fund or ETF is influenced by market factors which are beyond the control of the portfolio manager (i.e. price uncertainty).

Mutual Funds Share Classes can also be confusing

Investors have also found the various Mutual Fund Share Classes, their loads and various expenses, confusing and difficult to comprehend. See table below:

Retail investors purchasing funds from an Advisor often end up in A, B, or C share classes. 12b-1 are fees charged to cover the fund's marketing, distribution, and service costs. Institutional accounts usually pay low fees but face a minimum investment of $ 25,000+.

Differences between Mutual Funds vs. ETFs

ETFs have been gaining market share vs. Mutual Funds for three reasons. First, they can offer lower management fees vs. Mutual Funds. Second, they offer more flexible trading options (during the day vs. Mutual Funds at end of the trading day). Third, ETFs are more tax efficient vs. Mutual Funds.

Mutual Funds (1924) have had an large head-start on ETFs (which first evolved in 1993) and therefore maintain a large AUM (assets under management) advantage. However, ETFs can be traded on exchanges during the day, while Mutual Funds can't be liquidated until the end of the trading day.

Mutual Funds vs. ETFs Market Size & Flows

U.S. ETFs and mutual funds, by AUM

U.S. ETFs and mutual funds, by net flows

As shown (top chart) the Mutual Fund market share has fallen from 85% down to 66% since 2015. Since 2020, net inflows for ETFs (bottom) have occurred every year, while Mutual Funds have negative flows in 4 of the last 5 years.

ETF growth is growing at 19% CAGR

ETF assets have grown significantly over the past two decades.

U.S. ETF AUM ($Tn)

As shown in the chart above, most of the ETF market continues to be passive or index-based.

ETFs are more Tax-Efficient vs. Mutual Funds

• Mutual Funds transact in cash. When an investors sells shares, the fund sells securities to raise cash which creates a capital gain or loss in a taxable account. At the end of the year, the fund distributes capital gains to shareholders in the fund.
• ETFs, on the other hand, trade on an exchange like individual stocks so shares are sold on the open market. Thus, no underlying ETF positions are sold and therefore no capital gain or loss is created.
• In the event that the demand for ETF shares is unbalanced, market makers called Authorized Participants, transact share in-kind creation or redemption units. They take shares off the market when there is too much supply or create new shares when demand is high. In either case, this activity creates no cash transactions which avoids capital gain activity.

Minimizing Capital Gains makes ETFs Tax-Efficient

Tax efficiency spectrum across mutual funds and ETFs

ETFs are still mainly passively managed which makes them the most tax-efficient structure of the 4 options listed above.

‍

"American business-and consequently a basket of stocks-is virtually certain to be worth far more in the years ahead" - Warren Buffet

"Those of you who make investments outside of any retirement accounts are absolutely crazy if you are using actively managed funds rather than ETFs" - Suze Orman