Which should you choose, Mutual Funds or ETFs?

A lot has been written in the mainstream about mutual funds in comparison to Exchange Trade Funds (ETFs). However, most of it focuses on ETFs pursuing exotic strategies compared to more passive investment mutual funds. As many of you well know, you can get the same index based funds as either Mutual Funds or ETFs. Your decision will depend largely on your situation.

Mutual Fund Defined

Lets start with some understanding of what a mutual fund is. At its core, a mutual fund is a simple basket of other assets you purchase as a single unit. This unit trades at the value of its underlying assets, known as their net asset value or NAV. The value is set at the end of each business day and you acquire that security only at that time. Ultimately, you own the fund, not the assets underneath despite the pricing pass through.

ETF Defined

ETF or Exchange Trade Fund starts with the same step as a mutual fund. It is a basket of other assets you can purchase as a single unit. However, where it differs is it trades with a value separate from it’s underlying assets. The ETF essentially trades like a stock, constantly changing in value during the trading day based on peoples’ expectations of the performance of that ETF. In theory, the price does not differ far from that of the underlying assets or it would create an arbitrage opportunity where one could buy the ETF and sell the underlying assets, capturing a risk free differential.

The differences setup some interesting considerations:

1. Mutual funds tend to have classes of shares, with the more money invested allowing entry into a better class. These classes ultimately provide a lower expense rate the more you invest. ETFs meanwhile have no such structure, which often means even with a single share of an ETF you can have as low an expense ratio as a mutual fund involving significant investment quantities.
2. ETFs sell with a commission from your broker while mutual funds often trade for free. Exceptions are had if you buy the ETF through the broker that runs that ETF. For example, Schwab does not charge for it’s ETFs if you purchase through a Schwab account. As such, I consider this an insignificant difference.
3. Since an ETF trades separately from the value of the underlying assets, in periods of extreme price changes of the underlying assets the ETF may have issues with liquidity. The result of a reduction of ETF units trading on the market, the liquidity event can result in a significant difference between the value of those assets and the price of the ETF. Depending on the investment this can be a significant risk for either purchase or sale. Always purchase an ETF like a stock with a limit order, never a market order.
4. Even in a stable market there is some minor spread between the Bid, or price someone would pay for the ETF, and the Ask, or price at which someone is willing to sell it to you. This spread represents the transactional cost of trading the ETF and does represent a cost to you. You likely won’t notice this in normal situations. This cost is not present in a mutual fund since it is valued at the underlying asset value instead of being traded.
5. Often times Mutual funds have minimum investment quantities measured in 1000s of dollars.  ETFs meanwhile can be purchased in units as small as 1.
6. The final thing to understand is the difference in tax treatment. When you purchase a mutual fund you do so directly from the fund. The government typically requires that fund to distribute greater then 98% of its capital gains and dividends from the underlying assets to its owners. As such as the owner of these securities you have to pay taxes on the majority of the funds gains on the underlying assets every year.

How ETF’s Function

An ETF purchase meanwhile is not directly traded with the fund, but rather you do so with a large institution that creates the market. These market makers take your order and then go out and buy the underlying assets of the ETF. Then they trade those assets to the fund in exchange for a unit of the fund. Since the government considers this an in-kind transaction they are not required to distribute the gains at the same level. Also, since you can trade with the market maker, the selling of your ETF does not necessarily result in a sale of the underlying assets by the ETF, which would trigger a capital gains event for the fund. As such, you will see much less in terms of taxable distributions with an ETF unless you sell the security or receive a dividend.

Ultimately, the above means an ETF is ideal for a taxable account for holdings that are fairly stable or small when the ETF has a large trading volume. In comparison, a mutual fund is better suited for holdings that can be more erratic or might be less liquid.