ETFs and Mutual funds are two investments vehicles that can look very similar to the novice investor. Both are pool investments that give access to a basket of securities such as stocks, treasuries, bonds and other assets classes, offering an instant diversification in a cost effective manner. But beyond these very common characteristic lay some subtle differences that are worth looking into to make an informed choice between ETFs (Exchange-traded funds) and Mutual funds.
ETFs and Mutual funds are very similar in that they are both funds which invest in a pool of securities (usually stocks, bonds and money market securities). Both are bench-marked against underlying indices, meaning they invest mainly in the securities included in the index and their performance is compared to that of the index. Both are open to retail investors, unlike other types of investments funds like hedge funds, and both offer access to diversified and professionally managed investments at a low costs.
1. Minimum investment requirements
On the ETF side, there is no real minimum investment requirement other than the price to buy one share, so you could start investing via ETF with as little as $100, while most mutual funds do require a minimum amount to access their fund. Each Mutual fund will usually set a minimum investment requirement that is adequate its investment style and objectives.
2. Entry and Exit loads
Investing in a Mutual fund may come with a variety of loads. These are commissions that are paid by the investor and can take different forms. There are loads paid upfront which go to compensate an intermediary for their sales effort, also called front-end loads or entry loads, and there are exit loads ( also called back-end loads) which are paid when the shares are sold.
A third category of loads less known to the public is called the level-loads and is paid for the investment lifetime by the investor.
ETFs don’t have any entry or exit loads per say, but because they are traded in the stock exchange, there are other costs associated with investing via ETFs.
There could be trading commissions paid to the broker, although the tendency is towards commission free trading for stocks and ETFs. You also incur the bid/ask spread when you trade ETFs but the bid/ask spread tends to be narrow due to a high liquidity of ETFs.
3. Expense ratio
The expense ratio is defined as the total fund costs divided by the total fund assets. The total fund costs usually include management, custodians, accounting, taxes, and auditing fees and are reflected in the daily NAV calculation.
ETFs tend to have lower expense ratios than mutual funds because of their passive nature and lower operating costs. Mutual funds tend to have higher expense ratios due to being actively managed, among other things.
4. The price
As ETFs are traded in the stock exchange, they are quoted throughout the day based on buys and sells fluctuations, which means you can buy and sell ETFs at any moment of the day by putting orders with your broker.
Most of Mutual funds, on the other hand, are priced once a day after market closes and the calculated price is called NAV for Net Asset Value. This means you can buy or redeem Mutual funds shares only at the close of business NAV regardless of intraday market movements. Depending on what time of the day you place an order with your broker, the close of business NAV of the same day might not be applicable and only the next day NAV will be applied to your order.
5. Trading and liquidity
One of the biggest advantages of ETFs is the fact that they are traded like stocks in the stock exchange and thus share much of the stock features when it comes to trading. ETFs can be short sold, bought on margin and have an options market. They are quoted throughout the day and so can be traded at any point in the day. This results in a high liquidity of ETF shares under normal market conditions which drives the trading costs down (narrow the bid/ask spreads, low to free brokerage commissions).
Although some mutual funds are very liquid because there is a lot of interest in the market, Mutual funds shares tend to be less liquid than ETF shares because they have to be purchased and redeemed from the fund itself or through an authorized broker. They are only priced after market closes. This process typically results in higher operating costs and you might be required to pay an early redemption fee if you don’t hold your shares long enough.
When it comes to taxes, the determining factor of tax liabilities is the structure of the fund and its impact on how often the fund creates taxable events such as capital gain and income(payment of dividends or interests or any other income).
High vs low Turnover:
The turnover of a fund is an important indicator of tax efficiency. That is because when the turnover is high ( high buy and sell activities) increases the chance of triggering a tax liability when the fund sells stocks at a profit. Due to their passive nature, ETFs tend to have lower turnovers than Mutual funds which are actively managed (with exception of index funds).
Cash vs In-kind redemption:
When a redemption request is received, most of Mutual funds will exchange the shares for cash. To be able to honor the redemption request, these funds will have a cash reserve that they use as a buffer or they can use cash inflows to cover outflows. The problem arises when there is a net outflow of capital (more redemption request than inflows). In this case, the fund has to sell securities to cover the redemption, which may trigger a tax liability at every occurrence for the shareholders of the fund. Mutual funds can sometimes offer in-kind redemption, meaning they give in return of their shares a basket of securities on a prorate basis, but it is not a rule.
On the other hand, in-kind redemption is the primarily operating mode of ETFs, meaning ETFs exchange shares primarily for a basket of securities. The transaction requires an intermediary (a broker) who will facilitate the redemption. The intermediary will first receive shares to be redeemed from the investor. He then exchanges these shares for a basket of securities with the fund custodians, and finally exchanges the securities for cash with the investor. That way, the fund does not receive cash and its shareholders are not liable for capital gain tax in these events, but the investor who redeemed his shares will have a tax liability if the shares were redeemed for a profit.
Disclaimer: I am not an Investment advisor not a professional tax advisor. This blog post is for informational purposes only and is not intended to be an investment nor a tax advice. You should always consult with a investment advisor or a professional tax advisor for details about your investments and their tax implications. Investments are risky and past performance is no guarantee of future performance.
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