The similarities between exchange-traded funds and mutual funds aren't coincidental. Most, but not all, ETFs owe their existence to the same federal securities law that long ago gave rise to mutual funds. So at their core, exchange-traded funds and mutual funds are investment siblings. However the differences between the two are significant, and investors should understand them well.
- Trading shares: Mutual fund shares can only be purchased at the net asset value (NAV), which is the sum of all of the underlying securities, minus fees. Most mutual funds calculate the NAV at the end of the trading day, meaning shares may only be purchased and sold at prices that aren't known by investors who place orders before the NAV is established. ETFs can be traded throughout the day at prices known by investors. ETFs typically trade close to the value of the underlying holdings.
- Investment philosophy: Most ETF managers attempt to match the returns of benchmark indexes, minus fees. They do that by using a passive management approach, meaning they purchase the securities that make up indexes, such as the Morningstar Large Cap Index or the S&P 500. Most mutual funds are actively managed, which means their goal is to beat the returns of benchmark indexes.
- Capital gains distributions: Both ETFs and mutual funds can pay capital gains distributions, which may be taxable events for investors. However, according to IndexUniverse, the vast majority of ETFs have never paid capital gains distributions (largely due to lower portfolio turnover); most actively managed mutual funds pay gains regularly. A Morningstar study release in January 2012, “ETFs Under the Microscope: Tax Efficiency Survey,” showed that distributions among actively managed large-cap blend mutual funds averaged 1.92 percent of fund assets each year. Large-cap blend ETFs, meanwhile, paid no distributions. The gap was even larger in other categories. Among small-cap blend mutual funds, the average annual distribution was 3.54 percent. ETFs again, were at zero.
- Expense ratio: Expense ratios act as a drag on performance -- lower is better. Actively managed mutual funds tend to have higher expense ratios than ETFs.
- Transparency: Most ETFs publish daily the precise securities held and in what percentages. Mutual funds disclose portfolio holdings quarterly.
So what does all of that mean? ETFs can be a powerful tool for investors. Active traders have long been drawn to ETFs because they can be traded continuously throughout the day. Buy-and-hold investors tend to like ETFs because of their low fees, their transparency, and their tax efficiency.
The fact that ETFs must be purchased through a brokerage account has been a drawback for investors who want to rebalance or dollar-cost average small sums. Commissions can make those strategies impractical. That’s been somewhat alleviated because a handful of brokerage firms now offer commission-free trading of ETFs. Focus TM Morningstar ETFs, for example, can be purchased commission-free online by Scottrade customers and Scottrade Advisor Services advisors.
Like any investment vehicle, mutual funds and ETFs are not necessarily suitable for everyone. Many come with major risks of investment loss. So make it a point to educate yourself about ETFs and mutual funds before you buy shares.
— Erik Liik is president and CEO of FocusShares LLC, a Montvale, N.J., subsidiary of St. Louis-based Scottrade. FocusShares offers 15 domestic equity exchange-traded funds. For more information on FocusShares, go to www.focusshares.com.
[Disclosure: Consider the investment objectives, charges, expenses, and risks of an ETF or mutual fund carefully before investing. A prospectus containing this and other information should be obtained from the issuer. The prospectus should be read carefully before investing. Focus Morningstar ETFs are commission-free for those using Scottrade's online platforms. Investors not affiliated with Scottrade are subject to commission costs. Morningstar is a service mark of Morningstar Inc. and has been licensed for use for certain purposes by FocusShares LLC (an affiliate of Scottrade Inc.). The Focus Morningstar ETFs are not sponsored, endorsed, sold, or promoted by Morningstar, and Morningstar makes no representation regarding the advisability of investing in Focus Morningstar ETFs.]