The open-end mutual fund first debuted in the United States in 1924, with the introduction of the Massachusetts Investors Trust. However, with the stock market crash of 1929 and the ensuing Great Depression, mutual fund investing was subsequently put on hold until the creation of the Securities and Exchange Commission (SEC), and the enactments of the Securities Act of 1933 and Securities Exchange Act of 1934. These Acts provided important new safeguards and protections for investors which allowed the mutual fund industry to become a permanent and relevant part of American investment and finance.
For most investors, the traditional mutual fund has been the investment vehicle of choice since the 1950s, following the end of World War II and the economic expansion that followed. Mutual funds were (and are) a relatively inexpensive investment vehicle that allowed everyday investors access to professional money managers and instant portfolio diversification. Prior to the advent of mutual funds, if you wanted professional money management, you had to go out and hire someone to create, implement and track a portfolio of individual stocks and/or bonds, tailored specifically to your needs. As you can imagine, the time, effort and cost involved with finding, hiring and retaining such a manager put professional money management far out of reach for the average American. The invention and adoption of the mutual fund was the start of the democratization of investing, allowing the masses nearly the same investment opportunities as those previously only afforded the ultra-wealthy.
Many years ago, when we started creating and implementing investment portfolios for our clients, like most financial planners and investment managers at that time, we also used traditional mutual funds as our basic investment vehicle. However, these days, at Topel & DiStasi Wealth Management, we primarily use a different investment vehicle, known as the “Exchange Traded Fund” (ETF), when constructing and implementing our proprietary investment portfolios. And, while mutual funds are still the most prevalent type of diversified investment vehicle in use by investors today, the use of ETFs has been growing exponentially in recent years, and, in fact, new money is flowing into ETFs at a much faster rate these days than their cousin, the traditional mutual fund.
According to the Investment Company Institute, as of the end of 2021, there were 2,690 ETFs in the United States with a total combined value of approximately $7.2 trillion in assets, while there were 8,887 mutual funds with a total combined value of $27 trillion in assets. In other words, as of 2021, there was still almost four times as much invested in mutual funds as there was in ETFs. However, according to Morningstar, in 2020 ETFs had net inflows of $502 billion while mutual funds had net outflows of $289 billion. As you can see, the tide is definitely turning. And with this massive shift under way, it is important that investors know the differences between these two investment vehicles, because while the basic tenets of the two are very similar – low-cost diversified investment portfolios – there are some important differences to understand.
Difference #1 – Timing/Pricing of Buys & Sells
Traditional mutual funds cannot be bought or sold during the trading day. When you put in an order to buy or sell a mutual fund, you never know exactly what price you will pay or receive, since the order will not be executed until after the market has closed for the day. For many long-term investors, this is not a problem, because they are not worried about the daily fluctuation in price. However, if you are trying to buy or sell during a fast-moving market (up or down), and you are trying to buy or sell only at a specific predetermined price, mutual fund investing can be frustrating and potentially costly as well.
ETFs on the other hand, can be bought or sold while the markets are open. Just like buying an individual stock or bond, you can enter an order to buy or sell an ETF while the market is open, and you can specify at what price you are willing to buy or sell. As such, you have much greater control and clarity when buying an ETF, as compared to buying a mutual fund.
Difference #2 – Cost
In most cases, mutual funds are more expensive to own then ETFs. With traditional actively-managed mutual funds, the whole idea is for the manager of the fund to “beat” (i.e., out-perform) a specific index or group of managers in their investment category. In order to do so, a mutual fund manager must always be on top of the latest research on any company or potential company that they might want to include in their portfolio. That means travelling to meet with company officers, digging into the financials of them and their competitors, schmoozing management with dinners and golf and so on – basically, anything to get a step ahead of everyone else who is studying the same universe of securities in order to gain an advantage. These activities are costly and time-consuming, and because these operating costs are then subtracted from the returns of a mutual fund, the truth is that it is very difficult for most managers to consistently beat the indexes they are tracking over the long term.
On the other hand, most ETFs are based on passive investment strategies. This means that ETFs create a diversified basket of securities (stocks and/or bonds) based on either a mathematical formula or some other predefined strategy. Thus, with passive ETFs, there is no investment manager to pay, very little trading, and no travel or schmoozing of management, with the result that, in general, the internal costs of running an ETF are usually significantly lower than running actively-managed mutual funds. Which, in turn, means fewer costs passed on to the investor.
Kiplinger Magazine reported in 2021 that the average internal fee for an actively-managed mutual fund stood at 0.66%, while, for a passive ETF, the average internal fee was 0.09%. And while this may not seem like a huge difference, I think it’s worth a closer look.
If you were to invest $10,000 into a mutual fund that returns 10% per year before fees, which means 9.34% per year after fees (assuming the average 0.66% charge for mutual funds mentioned above), at the end of twenty years, you would have approximately $59,645.
On the other hand, if you were to invest $10,000 into an ETF that returns 10% per year before fees, which means 9.91% after fees (assuming the average 0.09% charge for ETFs mentioned above), at the end of twenty years, you would have approximately $66,180.
That is a difference of $6,535, or almost 11% more with the ETF as compared to the mutual fund. This is a great example of the power of compounding and the importance of owning low cost investments for the long-run.
Difference #3 – Tax Efficiency
This is probably the least recognized, yet most important, difference between mutual funds and ETFs. In general, ETFs are significantly more tax-efficient as compared to the traditional mutual fund.
When you own an investment (mutual fund, ETF, stock, bond, etc.) in a taxable (non-retirement) account, all dividends, interest and realized capital gains are taxable to you in the year they were received. And while interest and dividend payments are similar for both mutual funds and ETFs, capital gains are not.
When you own a traditional mutual fund, at the end of the year, there are often what are called “Capital Gains Distributions.” Even if you personally have not sold any of your mutual fund shares, and even if the mutual fund has lost value since you purchased it, you still may receive these distributions. I know, it sounds like a good thing, right? Who wouldn’t want a capital gain distribution? In reality, it is not a good thing at all, because what you are really receiving is some of your own money back that you did not ask for, and paying taxes on it.
Here is an example…
Let’s say XYZ mutual fund has owned Apple stock for 20 years and these shares have gained in value significantly during that time. This year, the mutual fund manager of XYZ fund decides to sell some or all of these Apple shares. The realized gain from this sale is sent out to the mutual fund shareholders on a pro-rata basis, according to the number of shares they own. So, if you own 1% of the mutual fund, you receive 1% of the realized gains. If you own this mutual fund in a taxable account, these gains will be reported on a form 1099 and you will owe taxes on these gains come tax time. But here’s the rub. Even if you have only owned XYZ mutual fund for a few days, or weeks, or months, and even if, in the time you have held the mutual fund, Apple stock has actually declined in value, you, as a current shareholder, still get a pro-rata portion of the gains to pay taxes on. So unless you have owned the mutual fund for the entire time it has held Apple stock, you get the privilege of paying taxes on someone else’s gains. This can happen, even if you have lost money in the mutual fund since you first invested. Talk about rubbing salt in a wound!
ETFs can also have capital gains distributions from time-to-time. However, due to the structure of an ETF versus the structure of a mutual fund, and because of the passive (i.e., low-frequency trading) nature of most ETFs, these capital gains are almost always lower, if they even occur at all.
Mutual funds have been an incredible boon to the investing public since their introduction, and the origins of the ETF can most definitely be traced back to that innovative product, and the democratization of investing that it ushered in with it. However, with progress and innovation comes change, and while change is not always better, better always comes from change. In this case, we very much believe that ETFs have evolved into the superior investment vehicle for the vast majority of investors.
This commentary on this website reflects the personal opinions, viewpoints and analyses of the Topel & DiStasi Wealth Management, LLC employees providing such comments, and should not be regarded as a description of advisory services provided by Topel & DiStasi Wealth Management, LLC or performance returns of any Topel & DiStasi Wealth Management, LLC Investments client. The views reflected in the commentary are subject to change at any time without notice. Nothing on this website constitutes investment advice, performance data or any recommendation that any particular security, portfolio of securities, transaction or investment strategy is suitable for any specific person. Any mention of a particular security and related performance data is not a recommendation to buy or sell that security. Topel & DiStasi Wealth Management, LLC manages its clients’ accounts using a variety of investment techniques and strategies, which are not necessarily discussed in the commentary. Investments in securities involve the risk of loss. Past performance is no guarantee of future results.