For investors who are looking to diversify their investment portfolio or to minimize the risks inherent with purchasing only one stock, mutual funds have historically been touted as the investment vehicle of choice. Major investment firms such as Vanguard and Fidelity have even made their names by offering a plethora of mutual funds to investors. Unfortunately, many of these mutual funds are not only plagued by undisclosed trading costs but with the tendency to underperform. In fact, only a small percentage of mutual funds will outperform their benchmarks (e.g., S&P 500).
Luckily, there is now a class of fund that not only carries low trading costs, but routinely outperforms its benchmark. Since its inception in 1993, the Exchange Traded Fund, or ETF, has been popular with the public investor because it can be traded like a stock and has very low maintenance costs. The ETF also offers an easy exit strategy; liquidity can be achieved by simply selling one’s shares without incurring any penalty fees. For investors of limited capital, the ETF is also attractive because one can purchase as little as one share.
ETFs are a collection of stocks, commodities, or bonds that are organized into an investment fund and then traded on stock exchanges. The ETFs are managed by an authorized participant (also referred to as a market maker or specialist), with the stocks themselves typically loaned out of different pension funds. Because ETFs are created from a large pool of equities, the authorized participant is typically a leading money management firm such as Barclays Global Investors. The authorized participant will often buy or sell ETF shares from fund managers in large blocks called creation units, and these units can range from 25,000 to even 200,000 shares. Because an ETF is bought and sold in creation units and is most often exchanged for underlying securities that are already trading on the market, the ETF’s daily trading price remains about the same as its net asset value (NAV).
On the exchanges, an ETF is traded much like a regular stock. Public investors can buy and sell ETF shares throughout the day using a broker. If there is strong investor demand for the ETF, its price per share can rise. This rise in price will typically lead the authorized participant to purchase additional creation units, leading to an increase in the ETF’s market capitalization while reducing its premium over NAV (i.e., appreciation).
The authorized participant makes most of his or her commissions from the bid-ask spread of the ETF and on price differences between the stocks making up the ETF and the ETF itself. The fund manager charges a nominal annual fee on the assets from which the ETF is composed, and the investors whose stocks make up the funds receive a small interest charge in exchange for loaning those stocks. All these fees are clearly stated in the ETF prospectus.
Mutual funds, meanwhile, operate on a different platform. Rather than starting out with ready-made stocks, a mutual fund is created when public investors send money to the investment firm. Once sufficient capital is accumulated, investment managers make decisions on what stocks will be purchased. The fund is established and is typically compared against a benchmark such as the S&P 500 or a specific industry. While some mutual fund managers are quite adept at picking winning stocks, many others are not. In general, only a small percentage of mutual funds will outperform their benchmarks. One example of the general underperformance of mutual funds is the Vanguard 500 mutual fund, which did not make any recent capital gains distributions; by comparison, the Barclays iShares S&P 500 ETF did.
Because mutual funds are actively managed by one or even several investment managers, the expense ratio of these funds can be high. Many different fees can be incurred when buying, holding, exchanging, or selling a mutual fund. Sales loads are a commonly used method for compensating the brokers who sell mutual fund shares, and the SEC permits sales loads to be as high as 8.5%. So-called “no load” mutual funds may charge purchase fees, exchange fees, and redemption fees instead. In some cases, mutual funds may charge an account fee, which is the fee charged for simply holding an account with the investment group (often charged if the account value is less than a given dollar amount).
Mutual funds also often charge so-called “12b-1” fees, which are fees that cover distribution and shareholder service expenses. The 12b-1 derives its name from the SEC rule that authorizes the payment of these fees. Distribution fees typically cover marketing, advertising, and prospectus printing and mailing. Shareholder service fees include general customer service and investor information. Together, distribution and shareholder service fees can be as high as 1% of the fund’s assets.
The inherent structure of mutual funds can cause significant problems with capital gains taxation. Should a significant percentage of investors decide to sell their mutual fund shares, that fund may need to sell a significant portion of its stock portfolio in order to obtain the cash for a mass payout. A sudden stock sell can lead to capital gains taxation and other IRS issues. ETFs do not have this problem because they are derived from existing stocks that are merely loaned out from other investors.
Finally, the minimal investment amount for many mutual funds is often in the tens of thousands of dollars, which disqualifies many investors of modest investment means. In contrast, ETFs are priced at the individual stock share level, with many ETF shares priced under $100. In some cases, an ETF may be priced as low as low as $20 per share (e.g., NYSE:EMT).
In summary, both mutual funds and ETFs offer investors the opportunity to purchase shares in a wide array of individual stocks in order to diversify their portfolios and reduce risk. In comparison to mutual funds, however, ETFs have significantly lower trading costs and lower monetary thresholds for entry. Most important of all, ETFs consistently outperform their benchmarks, while only a handful of mutual funds do likewise.