Mutual Funds vs. ETFs
Similar to mutual funds, exchange-traded funds (ETFs) are a diversified portfolio of individual securities (stocks and/or bonds). However, while ETFs are similar to mutual funds in that they are a diversified basket of individual securities, ETFs are different because of their structure and how they are bought and sold. For example, ETFs get their name Exchange-Traded Funds because ETF shares are traded on the stock exchange like an individual stock. This is one example of the unique advantages ETFs have over mutual funds. These advantages collectively lead to significant cost reductions versus mutual funds. The advantages can be summarized as follows:
[Note: In addition, ETFs don’t charge investors marketing, distribution, and accounting expenses; only mutual funds charge investors 12b-1 fees, upfront or back-end loads.]
In addition, when the mutual fund’s professional money manager (discussed above) decides to sell one security and buy a new security, the mutual fund pays commissions on each purchase or sale.
The net result for investors is that the commissions a mutual fund (and therefore a mutual fund owner) pays can easily add 0.50% to 1.5% (50 to 150 bps) annually in costs to a managed mutual fund.
An ETF does not incur commissions to buy and/or sell securities within the fund like a mutual fund does. First, ETFs are index funds and don’t have a professional manager buying and/or selling securities. ETFs only make changes to the portfolio on rare occasions when there is a change to the index.
There are also structural differences in how ETFs are created and grow. ETF shares are created when financial institutions deposit large baskets of individual shares of stocks in-kind into the fund. In exchange, the institution receives ETF shares from the fund. Because individual investors don’t buy or sell shares directly from the ETFs, the ETF doesn’t incur commissions to invest cash they receive from buyers, nor do they incur commissions to sell securities in order to raise cash to redeem those who wish to get out of an ETF. When individuals buy or sell ETF shares, rather than going directly to the fund, they go to the securities exchanges and buy or sell shares of an ETF just like they buy or sell shares of a stock. As a matter of fact, ETF shares can even be bought on margin or sold short — something that cannot be done with a mutual fund.
The ETFs redeem outstanding shares when a financial institution purchases large baskets of individual securities from the ETF using ETF shares rather than cash. These large baskets of securities that institutions use to purchase or redeem ETF shares vary in size as determined by each individual ETF, from 25,000 to 200,000 shares and they are called “creation units.”
As noted above, ETFs don’t purchase or redeem an individual investor’s shares directly as a mutual fund does. Instead, an individual investor simply buys or sells their ETF shares on the stock exchange to other investors as they would any other security. So ETF investors generally realize capital gains only when they sell their ETF shares to other investors at a price above their cost basis.
Consequently, this tax liability paid by investors in mutual funds can be 0.5% to 1.5% (50 to 150 bps) or more of invested assets each year.
The structure of Exchange-Traded Funds reduces management fees, commissions, and taxes. The annual savings of investing in ETFs rather than managed mutual funds can easily exceed 2% to 3%.
Note: This information is not intended to be tax advice. Check with your tax or financial advisor before making any changes to your investment portfolio. This paper is provided for information purposes only. The tax savings information provided here applies to taxable accounts only. If you are holding mutual funds or ETFs in an IRA or other tax-qualified account, you generally won’t pay taxes on gains until you take distributions from your account.