Mutual funds and ETFs (exchange traded funds) are both popular investment vehicles, but they have some key differences in their management, structure, costs, and trading mechanisms.
1. Management Style
Mutual Funds (typically actively managed)
- Management: Actively managed mutual funds are overseen by professional fund managers who make decisions about how to allocate assets in the fund. Their goal is to outperform the market or a specific benchmark.
- Research and Analysis: Fund managers use various strategies, research, and market analysis to select investments they believe will perform well.
ETFs (typically passively managed)
- Management: Passively managed ETFs (often referred to as index funds) aim to replicate the performance of a specific index (like the S&P 500). They do not try to outperform the market but to match its performance.
- Investment Strategy: The fund manager’s role is minimal, primarily focused on ensuring that the ETF’s holdings accurately reflect the index it tracks.
2. Structure and Trading
Mutual Funds (Actively Managed)
- Purchasing and Selling: Shares are bought and sold directly through the fund company at the net asset value (NAV) calculated at the end of each trading day.
- Minimum Investments: Often have minimum investment requirements.
- Flexibility: Investors may have restrictions on buying and selling, for example just once per day, after the market closes.
ETFs (Passively Managed)
- Purchasing and Selling: ETFs are traded on stock exchanges, and shares can be bought and sold throughout the trading day at market prices, similar to stocks.
- Minimum Investments: Generally, no minimum investment requirement beyond the price of one share.
- Flexibility: Prices fluctuate throughout the day just like a stock based offering greater flexibility and real-time trading. You can buy and sell whenever that market is open (typically during business hours).
3. Costs
Mutual Funds (Actively Managed)
- Expense Ratios: Typically higher expense ratios due to all the costs associated with trying to outperform the reference index. So more staff for active management to help with research, and also often more trading costs. These costs can be 2-3% or more. Therefore if the return they make is 10% you can be left with 7-8% instead due to their fees. Over 20 years or more this makes an immense negative impact on your overall returns. The fund would have to consistently outperform the market by 2-3% every year for those 20 years for you to just break-even. There are not even 10% of active managers that have done over any 20 years period. So beware of annual actively managed fees!
- Sales Loads: Some mutual funds charge sales loads (commissions) on purchases or redemptions.
- Additional Fees: May include other fees for marketing and distribution.
ETFs (Passively Managed)
- Expense Ratios: Generally lower expense ratios due to the passive management approach. As an estimate, I typically suggest you aim for less than 0.3% in annual fees for an ETF, many go as low as 0.1%. That means that if the ETF tracks the S&P500 (the biggest diversified index in the world) and that index goes up 10% for the year. Your net return should be close to 10% (9.9% averaged out over the entire year) less any trading costs you had (refer next point below).
- Trading Costs: Investors typically incur brokerage fees when buying or selling ETF shares but with many low cost online brokers your day-to-day trading fees for ETFs can be much less than $1. So if you invest $500 a month for example, your brokerage fee on that trade is just 0.02%. So therefore a very small impact on your net return.
- No Sales Loads: Typically, ETFs do not have sales loads, but some brokerage accounts might charge commissions.
4. Tax Efficiency
Mutual Funds (Actively Managed)
- Capital Gains Distributions: Actively managed mutual funds may generate capital gains through frequent trading, which are distributed to shareholders and can result in tax liabilities even if the investor has not sold any shares.
- Tax Events: Shareholders might face tax events when the fund manager buys and sells securities within the fund.
ETFs (Passively Managed)
- Tax Efficiency: ETFs are generally more tax-efficient because they have an in-kind creation and redemption process, which helps minimize capital gains distributions.
- Lower Turnover: The lower turnover in passive management strategies typically results in fewer taxable events.
5. Performance Goals
Mutual Funds (Actively Managed)
- Goal: Aim to outperform their benchmark or peer group through active management and strategic asset allocation.
ETFs (Passively Managed)
- Goal: Aim to replicate the performance of a specific index as closely as possible, not to outperform it.
Summary
In summary, actively managed mutual funds rely on professional managers to make investment decisions with the goal of outperforming the market, usually at a higher cost and with potential tax implications. Passively managed ETFs aim to mimic the performance of an index, offering lower costs, tax efficiency, and real-time trading flexibility. Investors choose between these options based on their investment goals, risk tolerance, cost considerations, and preferences for management style.
My general advice for most people who just want to safely invest over many years is to invest in ETFs (index trackers) over mutual funds, as probably the best strategy for most people. The major ETFs which mimic the major indexes (and they do that rather efficiently) charge very low fees (aim for 0.1-0.15% per annum) whereas most mutual funds can be over 1% or even significantly higher. Sadly history does not support the additional fees in all but very rare cases. This answer applies globally to any market you wish to invest in.
The most popular and biggest diversified stock ETF tracking the S&P500 is the SPY. It is run by a company called State Street. The expense ratio is just 0.09%. It is currently the biggest tracker of the S&P500 index. Although there are a couple of others which are definitely worth considering of very similar size and scale run by big reputable asset managers. The VOO (run by Vanguard) and the IVV (run by Blackrock) are both equivalent and because they are not as well-known their fees are even more competitive at 0.03%. Please note fees are accurate at the time of writing. You can refer to this link to check current fees. All of this said, the difference between 0.09% and 0.03% is incredibly small. All three are run by the three biggest index trackers so all three should be considered rather equal.
The only extra consideration for investing in the S&P500, for non-US investors, is the currency exposure. So if you live in the UK, Europe, Canada, Australia or anywhere other than a US dollar country, you will have fluctuations in return due to the movements of your currency relative to the US dollar. In general, and to avoid over explaining the nuances in this particular post, if you average your investment over a long time period – the safest long term way to invest in an index tracker. For example, $500 a month for 10 years. Then the impact from currency fluctuations should likely average out and have little real impact relative to most major currencies. So currency risk should not stop you from investing in the most diversified global index simply because of this reason. The returns you gain by investing in the companies within the S&P500 will likely far outweigh the minor gain/loss you may experience from currency fluctuations.
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