ETFs vs Mutual Funds: A Few Things You Need To Know

Two of the most common products held by both institutional and individual investors are mutual funds and ETFs. While there are some similarities between these products there are also important differences that you should know about.

In most cases ETFs offer a superior investment product and that is why ETF assets under management (“AUM”) has been growing at 16% per annum (2016-2022) vs mutual funds which have been growing AUM at 5% per annum. In 2022, ~70% of all new fund launches were ETFs.

1. ETFs Are Generally Much More Tax Efficient Than Mutual Funds

Tax efficiency is arguably the biggest advantage that ETFs have over mutual funds.

There are two key reasons why ETFs tend to be more tax efficient than mutual funds: low turnover and ETF holders are insulated from actions of other holders.

The vast majority of ETFs are index funds which typically do not require much trading. Comparably, most mutual funds are actively managed. A high degree of active management means more buying and selling of securities which often results in capital gains. Towards the end of the year mutual funds must distribute any net realized capital gains earned on their holdings over the prior 12 months. These capital gains are taxable to an investor even if the investor has not sold any shares and the money is reinvested into additional shares. Comparably, ETFs based on index funds do not trade much (other than rebalancing) and thus tend to create capital gains only upon sale.

When a mutual fund receives significant redemptions it must sell assets in order to raise cash to meet the redemption request. The result is mutual funds are often forced to realize capital gains which get passed on to existing fund holders at the end of the year. On the other hand, ETFs accommodate inflows and outflows by creating or redeeming creation units. Thus, ETF inflows and outflows do not create a taxable event to existing fund holders.

According to BlackRock, ETFs held 24% of U.S. managed fund assets at the end of 2021 but accounted for less than 1% of capital gains distributions. Moreover, the average annual tax cost for active U.S. large-cap mutual funds was 2.09% for the 10 years ending in 2021 

2. Mutual Funds Tends To Have A Cash Drag

Due to the fact that they must be prepared to meet investor redemptions at anytime, mutual funds tend to hold a small amount of cash at all times. A recent study suggests this results in ~6bps of passive mutual fund underperformance vs ETF peers. Vanguard founder Jack Bogle previously estimated that the cash drag accounts for 0.15% of annual underperformance. For example, the Fidelity Contrafund (FXNTX) is one of the largest actively managed equity mutual funds in the world with ~$105 billion in assets. FXNTX currently holds ~3.74% in cash. While the impact of the cash drag will be small in any given year, the cumulative impact is more meaningful over long holding periods. Comparably, ETFs tend to hold much lower levels of cash as they do not need to worry about meeting investor redemptions.

3. ETFs Can Be Traded Throughout The Day While Mutual Funds Can Only Be Traded Once Per Day

Another significant advantage that ETFs have over mutual funds is that they trade like stocks and are bought and sold on a stock exchange. This means that investors have the ability to buy or sell at any point during the day. Comparably, mutual fund orders are only executed once per day at the next available net asset value which is determined after the market close each trading day.

One important consideration to note here is that it is possible for ETFs to become disclosed from their NAV during the trading day. This is rare and tends to happen only in a very high volatility environment but this is something that investors should be aware of when transacting. On the other hand, mutual fund buy and sell orders are always executed at the next available NAV.

4. ETFs Can Be High Fee and Mutual Funds Can Be Low Fee

Generally speaking investors tend to associate mutual funds with higher fees due to the high percentage of active funds while associating ETFs with lower fees due to high percentage of index funds. However, investors need to be aware of that fact that high fee ETFs exist and low fee mutual funds exist.

In recent years the ETF market has continued to evolve and one of the fastest growing parts of the market is active ETFs. One example of a high fee ETF is a rather complex fund called the Strategy Shares Nasdaq 7HANDL Index ETF (HNDL) which charges an annual expense ratio of 0.96%, well in excess of the active equity mutual fund average fee. I am not a fan of this fund and if you want to learn why please check out my recent article on Seeking Alpha: HNDL: Avoid Due to High Fees And Complexity An example of a low fee mutual fund is the Vanguard Stock Market Index Fund (VTSAX) which has an expense ratio of just 0.04%.

The takeaway here is investors should also closely evaluate fund expenses and not assume that ETF always means low fee while mutual fund means high fee.

Takeaway

Despite the rise of ETFs, mutual funds remain the dominant force in portfolios accounting for ~75% of U.S. managed fund assets. The primary reason for this is that mutual funds arrived first (the first mutual fund was launched in the U.S. in 1924) and became entrenched in investor portfolios. Comparably, ETFs are a rather new product having been launched in 1993. People do not like change and thus have been slow to embrace the benefits of ETFs.

In recent years managed fund assets in ETFs have been growing much more quickly than mutual fund assets as investors have started to embrace the advantages of ETFs including tax efficiency, all day trading, and the lack of a cash drag.

Investors should consistently evaluate their portfolios and be sure to choose the most efficient way to get exposure.

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