Investing 101: Mutual Funds vs Exchange Traded Funds

September 15, 2014

Many investors choose investment funds to sock away their retirement savings. When discussing funds with their friends, coworkers, and families, the talk often gets confused over the similarities and differences between mutual funds and Exchange Traded Funds or ETFs.

Both types of funds take investor’s money and pool the investments to purchase a portfolio of securities with each investor owning a unit or share of the portfolio. The major differences are in how the funds are bought and sold. But there are several other features that you should be aware of.

Buying and selling funds

You buy mutual funds through your investment dealer, plan sponsor if you are investing in an IRA, Roth, 401k, or similar savings plan, or directly from the mutual fund company. The price you pay for the fund is based on the net asset value of the fund calculated at the day’s close. Depending on where you buy the fund and the type of fund that you purchase, you may be charged a sales charge which is a percentage of the dollar value invested.

The ETFs are purchased through an investment dealer and are traded on an exchange registered with the SEC. When you purchase the ETF your transaction is processed immediately on the exchange at the current price level. This will be close to the current net asset value rather than the closing value. The cost of the transaction is the commission that you pay to the dealer and is usually a small flat rate.

So when buying and selling the funds, there are two major differences: the timing of when the transaction is executed and the cost of the transaction.

Focusing on the cost differences

The mutual fund can have either no transaction cost or a very high transaction cost. You should investigate this and know what you are paying before you invest. Some funds charge high up front “load” fees or sales commissions when you make your purchase. When you buy the fund inside of your sponsored savings plan, most times there are no fees. This is important for regular contributions to the funds. If you are making small monthly deposits like you do in a retirement savings or a college savings plan, this is an attractive feature that saves you money.

The ETF, on the other hand, costs you a flat rate commission with every purchase and sale. The flat rate structure makes the ETF cost efficient for large deposits and cost prohibitive for small deposits. The ETF commission fees would be too high for the monthly savings plan. So focusing purely on the initial costs, the mutual fund would be best for regular savers and the ETF for one time buyers.

Considering other differences

Everything doesn’t always revolve around price -- there are lots of other factors to consider.

Many investors consider ETFs much more efficient than regular mutual funds. The ETFs are most often indexed to a basket of securities which are held by the fund. By minimizing purchases and sales of stocks within the funds, the ETFs can operate at a much lower cost. The operating and management fees charged by the ETF can be a fraction of the mutual fund fees.

The mutual funds may have higher operating and management fees as well as higher administrative fees. Remember the boiler plate disclosure you hear in the advertisement: “Before investing please read the prospectus for a full disclosure of fees and expenses"? The internal fees charged by the funds will be a major contributor to your investment performance.

To index or not to index?

Generally -- and this is an over-generalization with new, innovative ETFs -- the ETF funds are index funds that buy a prescribed basket of securities that match a market index like the S&P 500 stock index. While a mutual fund may match an index, most are not index tracking funds but rather driven by portfolio managers with a value creating active management strategy.

The active portfolio managers utilize their investing skill to achieve higher returns. The debate within the investment industry is whether active fund managers can consistently outperform their benchmark index and whether their performance justifies their higher costs.

Want to express your special interest?

Both mutual funds and ETFs target their products to investor’s interests. The mutual funds industry has been very responsive in offering funds for various asset classes and across international markets. Special interests like socially aware funds have been offered for years.

The ETFs, however, have created a plethora of offerings. The financial news service Bloomberg lists 5,600 ETF funds available to investors. Many of these new ETFs offer choices to express views on markets and tools such as leverage that were not previously available to fund investors.

How do you decide what’s right for you?

The best way to make the right decision for your investments is to educate yourself. Fortunately there are very good sources of unbiased information available for investors and plan sponsors to make investor education one of their priorities.

Here are a few:

The Securities and Exchange Commissio (SEC)
The Financial Regulatory Authority (FINRA)