COMPARING ETFs TO MUTUAL FUNDS

Exchange traded funds (ETFs) combine features of mutual funds and stocks. While ETFs share some features with mutual funds, there are some key structural differences that can affect your investment exposure and tax consequences.

Mutual Funds Index Mutual Funds ETFs Stocks
Diversified
Traded on exchange
Intraday pricing
Intraday trading
Management fees
Commission fees
Tax management¹
Index tracking
Mutual Funds Index Mutual Funds ETFs Stocks
Diversified
Traded on exchange
Intraday pricing
Intraday trading
Management fees
Commission fees
Tax management¹
Index tracking

 

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Strategy

All funds are a collection of individual securities which are bought and sold as the fund attempts to meet its investment objectives.

Management philosophies fall into one of two camps, often called “active” and “passive”. Active funds (most mutual funds) seek to outperform market indexes. Fund managers study the market and draw on their investment experience and expertise to try to maximize the fund’s performance. Mutual funds are required to provide investors with a fund objective and a map to an investment style, though the managers generally have some freedom to choose the investments they think will perform best.

“Passive” funds, by contrast, seek to match the fund’s performance to an established market index, such as the S&P 500 or FTSE 100. A passive fund’s performance is measured by how well it replicates its chosen index. Index funds and most ETFs fall into this category.

 


Trading

One difference between ETFs and mutual funds is in the way the funds themselves are traded, which has a few implications for investors.

Mutual funds are bought and sold directly from the mutual fund company at the current day’s closing price, the NAV (Net Asset Value). ETFs are traded throughout the day at the current market price, like a stock, and may cost slightly more or less than NAV.

Mutual fund transactions do not include commissions to a brokerage, while some ETF transactions do. (Check with your brokerage for their specific pricing structures).

 


Fees

In all funds, there are two types of fees to watch: transaction fees and the fees included in the fund’s expense ratio.

For mutual funds, transaction fees may include sales loads (or sales charges) or redemption fees. These are paid directly by investors. ETF transactions may include brokerage commissions (just as stock trades do), which are paid directly by investors.

The expense ratio represents the operating costs of a fund divided by the average dollar value under management as of the fund’s fiscal year end. The expense ratio is calculated annually and reported in the fund’s prospectus. The largest and most variable part of these costs is usually the fee paid to the fund managers—the "management fee".

Other aspects of these operating costs can include custodial services, recordkeeping, legal expenses, acquired fund fees and expenses (if the fund invests in other funds), accounting and auditing fees, or a marketing fee (called a 12b-1 fee). Operating expenses are taken out of the fund itself and therefore lower the return to the investors. In general, funds that pursue an active investment strategy will have higher operating costs than passive funds.

Since fees vary so much across funds, investors should take time to understand all the fees associated with a fund they might purchase.

 


Tax implications

ETFs are typically structured with the aim to shield investors from capital gains taxes. Currently, nearly all ETFs are index funds – so, like index mutual funds, they typically trade less frequently than most actively managed funds and so generally create fewer taxable capital gains for fund-holders.

What’s the relationship between fund turnover and taxable capital gains? One key difference between ETFs and mutual funds (whether active or index) is that investors buy and sell ETF shares with other investors on an exchange. As a result, the ETF manager doesn't have to sell holdings − potentially creating capital gains − to meet investor redemptions. Mutual fund shareholders redeem shares directly from the fund. The fund manager must often sell fund securities to honor redemptions, potentially triggering capital gains which then trickle down to the fund’s investors.

Certain traditional mutual funds can be tax efficient and, of course, ETF shareholders can incur tax consequences when they sell shares on the exchange, but that tax consequence is not passed on to other ETF shareholders.

 


Transparency

Transparency is access to information about which stocks and/or bonds a fund holds—the batch of companies that you’re buying when you buy a fund share.

  • ETFs: Generally disclose holdings daily.
  • Mutual Funds: Generally disclose holdings quarterly.

Because of their longer disclosure cycle and the greater leeway that active fund managers have when choosing investments, some mutual funds have historically been affected by style drift, where the fund’s holdings can change over time and sometimes stray farther than the fund’s intended strategy than investors may realize. Knowing exactly what you are investing in is important information you need to make financial decisions.

In case you didn't know

Exposure Benchmark
The dollar amount of funds or percentage of a portfolio invested in a type of security, market sector or industry. The greater the exposure, the greater the risk. A standard against which performance is measured. One of the many indexes like the S&P 500 or the Russell 2000 are used to benchmark the performance of funds.

What is an ETF?

Learn more about the benefits of using ETFs to meet investment goals.

Video 4:00

ETF creation & redemption

Watch a video on this unique feature of ETFs and why it’s important.

If you’re familiar with exchanged traded funds, or ETFs, you may have heard the phrase Creation and Redemption. But let’s dig deeper into what it means and why it’s important? ETFs are low cost and tax efficient ways to access both broad and precise market exposures. They trade like stocks, can provide deep liquidity, and their prices are closely tied to the value of their underlying securities. But how is this possible? It’s all thanks to the processes of creation and redemption. To better understand how it works, think of an individual stock or bond as a flower. Just like companies come in different sectors and sizes, flowers come in all kinds of varieties and shapes. Now take a variety of flowers and bundle them into a bouquet, and you’ve got yourself an ETF. The price of an ETF is based on the price of the stocks or bonds that make up the ETF. So when the prices of individual flowers increase, so does the price of the bouquet. Now let’s say an investor wants to buy a bouquet, what does she do? She goes to a flower shop, which we can imagine as a brokerage firm. She goes to a flower shop, which we can imagine as a brokerage firm. Here, the investor browses bouquets and finds the emerging markets bouquet, the clean energy bouquet, and the S&P 500 bouquet. She decides to buy one S&P 500 bouquet. Like a florist, the broker dealer takes this order and sends the market maker out to the market to fill it. The market maker finds the S&P 500 bouquet, and brings it back to the shop. The investor pays the broker and gets the ETF she wants. Easy! But what happens if the investor wants _one hundred_ bouquets? Just as before, the broker dealer sends the market maker to get one hundred bouquets. But there are only five bouquets available. Just as before, the broker dealer sends the market maker to get one hundred bouquets. But there are only five bouquets available. So what’s the poor market maker to do? Thanks to the unique process of ETF creation, more bouquets can be made to fill the large order. The creation process kicks in as soon as the investor places the order. It begins with the authorized participant, or AP for short. The AP watches the market in order to manage the supply of flowers and bouquets. When the market maker can’t fill an order, he asks the AP to make extra bouquets. The AP checks the S&P 500 Index to find out exactly which individual flowers make up the S&P 500 bouquet. Once the AP has everything he needs, he gives the flowers to iShares. Similar to a bouquet designer, iShares assembles brand-new S&P 500 bouquets. Once they bundle the individual flowers, iShares gives the new bouquets back to the AP; the AP gives the bouquets to the market maker; and the market maker brings them back to the broker dealer, who in turn sells them to the investor at market price. Despite the size of the order, the price of the bouquets stays approximately the same due to the increased supply. Now let’s flip things around for redemption. The investor wants to _return_ one hundred bouquets, so the florist buys them back. He then gets the market maker to take the bouquets to the market to see who wants them. But there’s already an adequate supply of bouquets. So what does the market maker do now? Well, he turns to the AP again. The market maker gives the AP the bouquets, who then brings them to the iShares workshop where they are disassembled into individual flowers. And just like that, the number of bouquets decreases to meet market needs and keep bouquet prices stable. Creation and redemption occur to keep ETF supply in line with demand. This generally keeps ETF values closely tied to their underlying assets. And it allows you to easily trade ETFs throughout the day due to their deep liquidity. Visit iShares to learn more about ETFs today. Visit iShares.com to view a prospectus, which includes investment objectives, risks, fees, expenses and other information that you should read and consider carefully before investing. Investing involves risk, including possible loss of principal.