Investing Basics

What is an ETF vs. a Mutual Fund and which one is better for you?

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Debra Ohstrom, CFA is an online course creator who uses her financial expertise to empower women to take control of their financial future.

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ETF’s and Mutual Funds are similar in some ways where both can hold a group of bonds, stocks and other securities like options and some combine all of those together.   There are also quite a few differences which I will go through here and hope that you can get a sense of whether an ETF vs. a Mutual Fund may be right for you.

ETF’s stand for Exchange Traded Funds and were started back in the 1990’s.  They have grown enormously in the number and types of ETF’s available.  Just to get a sense of how the investment choices have grown, back in 2003 there were approximately 123 different ETF’s available and as of 2019 there are over 2000 listed on stock exchanges.   Some of the biggest differences between ETF’s and Mutual Funds are that ETF’s have more flexibility in the types of investments they can hold.  In addition to stocks and bonds they can borrow additional money and make their returns or losses even larger and these are called leveraged ETFs.  Many ETF’s invest directly in commodities where Mutual Funds would usually invest in other securities called futures contracts in order to earn similar returns to the underlying commodity.  Also, recently more ETF’s are incorporating options on stocks as a way to hedge downside risk in the stock market.    All of these are examples to say that ETF’s are given more flexibility in the types of securities owned within the ETF portfolio versus a Mutual Fund.

Trading Differences

The actual structure of an ETF and a Mutual Fund are different but both Mutual Funds and most ETF’s fall under the regulation of the SEC’s Investment Company Act of 1940.  They both are pooled investment vehicles and there are other articles available on the internet that go into the exact structure of how an ETF is created.  I would rather spend more time on what it means to you as an investor then the mechanics of the vehicle.   Mutual Funds are traded at the end of day price called the NAV (net asset value.)  This is when all the underlying holdings are valued and then the Mutual Fund is priced from there. This means Mutual Funds are only traded once a day so if you want to sell your Mutual Fund in the morning you still won’t get the price till the end of the day.  Obviously, if the market is going down all day, you have to wait till the NAV gets calculated and you get the end of the day value.  Since an ETF is traded like a stock, you can buy and sell during the day so the investor has more control when they can get into or out of the market.  There is also the ability to set trading rules around purchasing the ETF such as limit orders and stop orders just as when buying a single stock.  Let me explain these terms for you.

Trading Terminology

When looking at an ETF to invest in you will see it quoted with a bid price and an ask price.  The bid price is what an investor can currently buy the stock for and the ask price is what an investor can sell the stock for.  The difference is referred to as the spread.  The spread can be thought of as the cost to trade and can be impacted by the number of shares traded on a daily basis.   The higher the number of shares traded daily also called the volume then usually the smaller the spread between the buy and sell prices.

When you are in a brokerage account and are entering a trade for an ETF or stock you will have a choice as to how the trade will be executed.   The trading system will require you to pick whether you want a market order, a limit order or a stop order.   A market order means you request they fill the trade at the available market price as soon as possible.   A limit order allows you to choose a target price to fulfill the trade but it won’t get executed until the ETF or stock price meets that requirement.

Stop loss orders allow you to put in an order to sell an ETF or stock when it reaches a price below where you purchased the holding.   This will minimize your losses if the price falls.  A stop limit order allows you to specify a range for a trade so that you can initiate a buy for example at $12 per share but the limit is $15 per share and no higher so that the trade will get executed between that range if possible.  There is a risk that the order will not get executed at all if the limit price is reached and moves higher very quickly.

Tax Impacts                              

The way that ETF’s are traded also impacts how you pay taxes.  For example, if you are holding the ETF or Mutual Fund in a taxable account your gains or losses will need to be paid when realized.   An investor’s tax implications for an ETF are straight forward.  You would be responsible for the tax on gains when you sell the ETF at a higher price than when you bought it or record a loss if you sold it for less.   A Mutual Fund has a different structure and distributes their gains out to shareholders annually.  If you happen to have just bought into that Mutual Fund right before their tax distribution date you will have to pay your share of the tax even if you were not invested in the Mutual Fund all year to experience those gains.

Expenses and Fees

The last item I will mention is fees associated with ETF’s versus Mutual Funds.   Both of these have expense ratios and as I mentioned in previous articles passive index ETFs and Mutual Funds are generally lower than actively managed mutual funds and ETFs so it’s a number to be aware of.  These fees can be listed on the Factsheet of the Fund or ETF.   Its is something to be aware of because this is a percentage that will reduce your returns and can add up over time.   The other cost to consider are the transaction costs.  Many investment brokers have reduced transaction fees to zero on ETFs and stocks but that isn’t always the case with Mutual Funds so be aware and ask questions since this will impact your investment returns.

As you have read ETF’s have more investing and trading flexibility versus Mutual Funds and taxes get recorded differently so be aware how all of this can impact your performance over time.  Always ask questions of your advisor or investment broker if you aren’t clear on something.

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Debra Ohstrom, CFA is an online course creator who uses her financial expertise to empower women to take control of their financial future.

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