What’s the Difference between a Mutual Fund and an ETF?

There is a good chance that you have heard about Mutual Funds.  They have been around for some time and probably make up a good chunk of your parents’ RRSPs or RRIFs if they have any.

Mutual Funds come in many different shapes and sizes.  The vast majority try to utilize the skills of a portfolio manager to try and “beat” market returns (beating the market means getting an annually compounded return that is larger than a markets return, such as the S&P 500).  This is what is known as active investing.  It is active because the portfolio manager is actively selecting stocks that he/she thinks are underpriced.

The Mutual Fund will usually have a stated strategy for investment selection.  Strategies can include the size of the company or market cap (micro, small, mid, or large), the investment style (growth or value), industry (manufacturing, retail, energy, etc), geographic location (North American, European, Asia, etc), and many other factors.

The management is bound by these strategies and cannot invest outside of them.  For example, say a fund has a small-cap, foreign, retail strategy.  They could invest in companies outside of Canada who are considered to have medium market cap and whose primary product or service is in the retail industry.  This fund would not be allowed to invest in a large energy company inside Canada such as Enbridge.

Active investing means that the portfolio manager may participate in hundreds or thousands of trades a year (some can be much lower).  This has a couple implications on costs.  Because there is a higher turnover of equities (buying and selling) the fund must pay capital gains taxes on profits which are passed on to the investor.  The fund also has trading costs with every buy and sell they execute.  These fees are also passed on to the investor.

When you invest in a Mutual Fund you have to pay what is known as the MER or management expense ratio.  This is the fee the company charges to manage the assets in the account.  The average cost of the MER is between 2-3% of assets.  It is used to pay for daily operations, salaries, and other expenses the company may face.  On top of this fee you can expect to find some other fees as well.  Some include a trailer fee (this is paid to the advisor who sold you the mutual fund and is paid out each year), a commission fee (a onetime fee paid to the advisor), front-end or back-end loads (fees charged when you buy or sell a mutual fund), and possibly a DSC fee (kind of like a back-end fee but is reduced the longer you hold the mutual fund).

As you can see, Mutual Funds can start to get expensive.  But what do all these fees mean for your return?  Well, let’s say you have a fund that is making an 8% return before fees.  Your investment doesn’t actually increase by that amount because fees need to be reduced.  Let’s say you have a MER of 2.5% and a trailer fee of 1%.  All of a sudden your 8% return has shrunk down to 4.5%.  That is an okay number, but if you add in average inflation of 2% and your growth becomes a measly 2.5%.

Recent trends have pushed for lower MERs and one way investors are finding them is through passive investing.

There are Mutual Funds that use this method and they are known as Indexed Mutual Funds.  The goal of the fund is to simply mimic the returns of a major stock index such as the S&P 500, Dow 30, NASDAQ, or any index around the world.  Since you have no portfolio manager choosing stocks and usually use a computer algorithm to follow a chosen index, the fund can charge a much lower fee.  That 2.5% can drop down to say 1.25%.  The fund may still have the other types of fees attached to it, but the overall fee should be much lower.

What’s the disadvantage?  Some say that you get less return.  But this might not be true because historically it has been shown that portfolio managers as a whole have not been able to beat the market consistently.  There are obviously some managers who have been able to beat the market consistently, but they make up a very small percentage of the population.

In the past ten years, a new product has hit the investment world that tries to further reduce fees and act as a passive investment vehicle for investors to use.  This security is known as an Exchange Traded Fund or ETF.

An ETF is sort of like a Mutual Fund but with a few major differences.  The first big difference is how it is bought.  A Mutual Fund is usually bought through an advisor or financial institution.  The price is quoted only once a day and you usually have to pay the next day opening price or settlement date price for the fund.  An ETF is bought on the exchange just like a stock (hence the “exchange traded” in its name).  The price changes constantly while the market is open and it cannot be purchased when the market is closed.

Another big difference is fees.  A Mutual Fund can have many different fees attached to it (as stated above).  An ETF, on the other hand, basically has two different fees.  It too has a MER, but it is significantly lower, usually between 0.50% and 1.0%, but some can be as low as 0.15% (it all depends on what type of ETF it is).  The other fee is the brokerage commission fee.  Since an ETF trades on the exchange just like a stock, it is subject to a brokerage commission fee as well.  This is a onetime fee that is made during a buy or sale.  This fee usually runs between $5 and $20 no matter how many shares you buy (unless you get into really big orders which an individual investor probably would not make).  There are some new ETFs popping up that have no commission fees, but they do charge a little higher MER than the traditional ETF (usually between 0.75% and 1.25%).

The main focus of an ETF is to invest passively.  There are some ETFs that have begun to apply an active strategy, but the vast majority follows an index or a section of the market.  The strategy is to purchase a basket of securities that mimics an index and to leave it alone (some adjustments may need to be made via computers since the ETF may not track the index perfectly).

You can find ETFs on just about any market these days.  There are ETFs according to company size, investment philosophy, geographic location, industry, and even niches like socially responsible companies.  ETFs also allow investors to invest passively in fixed income securities, futures, commodities, and real estate.  Although some argue that futures and commodities ETFs are not really a passive strategy since they require constant buying and selling of contracts.

There is no doubt that ETFs are becoming more and more popular.  A big reason for this popularity is because of the strategy of correlation and diversification.  If you hold a basket of indexed products that have low correlations with each other, then you have successfully diversified your investments.  This diversity means that your portfolio will have less ‘shocks’ (a lower standard deviation).  It also means that you will have less ‘large’ returns, but the whole idea behind portfolio building and diversification is to reduce risk and produce steady returns.

ETFs fill this role so well because with only two ETFs you can effectively diversify a portfolio.  You could create a portfolio that is 60% invested in an S&P 500 ETF to represent your equity portion and invest 40% in a diversified Bond ETF to represent your fixed income portion.  With traditional investing, this would require you to buy approximately 30 stocks to get effective diversification and invest directly in bonds (which would be expensive and time consuming).

Mutual funds have historically been able to perform this function, especially indexed mutual funds.  But people are realizing that one major key to passive investing is reducing costs as much as possible.  All those extra hidden fees connected to mutual funds cause them to be more expensive, so ETFs have stepped in to fill that need for indexing at a reduced cost.

But don’t believe that ETFs are perfect.  Don’t forget they have a brokerage commission fee charge each time you buy and sell a security.  For long-term investors this should be no problem because you should technically only have to pay this fee twice (on purchase and on sale).  But, where this fee can really start to add up is if you engage in dollar-cost averaging.

Dollar-cost averaging means that instead of investing in one go; you purchase equally priced bits consistently over a long period.  What this does is average out the price you pay for a fund.  It also means you buy more units when they are down in price and fewer units when they are up in price.  As you can see this strategy can get expensive with ETF trading since you pay a fee for each trade.  Some Mutual Funds on the other hand do not charge a commission and may not have front-end or other up-front purchase fees.  This means you can invest small amounts periodically and not suffer from huge commission charges (but remember you end up paying a larger MER and possible trailer fees and other hidden fees).

It really all depends on how much you are investing each period with an ETF (month, quarter, year, etc).  If the commission is $10 per trade, then investing $1000 means you are paying a 0.10% fee (not that bad).  If you are investing $100 each period, then the fee becomes a 1.0% fee (not that great).

As always, there is a suitable course of action for each individual investor.  This is where a financial advisor can really be helpful.  What they can do is price out each option for you over a given time period (say 20 years) and find the cheaper solution.

But be warned that some financial advisors/planners and their companies may only provide you with Mutual Funds, so ETFs might not even be an option going that route (don’t forget that you are never tied in to a certain advisor and can transfer your assets if you want to invest using different methods than the ones offered).

ETFs can work really well for those individuals who are able to put away a decent savings each period and who are not afraid to self-direct their investments through an online broker such as those offered through major banking institutions or online discount brokers such as Questrade.

Whatever style of investment vehicle you choose, make sure you ask around, do your research, and choose what is right for you.  And never feel like you have to act right away, you won’t “miss out” on opportunities.  Any financial planner that forces you to move quickly into the market because of an “opportunity” should maybe be avoided, unless you like the aggressive type.

You should be making a portfolio for yourself that is able to stay afloat in any market.  Remember, no extreme highs and lows… smooth and steady gains are the key to the game for the average investor.

Thanks for reading and good luck out there!

So what do you think?  Do you prefer ETFs or Mutual Funds?  Are you into passive or active investing?  Comment below if you have some insight on the topic.

Warning/Disclaimer:  The above article is not investment advice for an investor to implement.  It is meant to educate the investor about options available for investment.  Talk to a licensed and accredited financial professional about investment strategies that are best for you and your situation.

Advertisements

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s

%d bloggers like this: