Exchange Traded Funds (ETFs) vs. Mutual Funds (I)

Large institutions, like pension funds, and very wealthy private individuals may be able to hire professional money managers directly.  But most of us deal with our money managers through intermediaries.   For a long time  investors had basically one choice, a mutual fund.  For about the past ten years, however, another alternative has been available, the exchange traded fund (ETF).

One topic, three posts

I’m going to talk about ETF vs. mutual fund in three posts.  This one, the first, will talk about the general structure and features of each.  The second will talk about index funds vs. index ETFs, including how both deal with international stocks.  The third will cover actively managed funds vs. actively managed ETFs.

Note that I’ll be talking about funds incorporated in the US. Details will be slightly different in other jurisdictions.   Also, when I say “mutual fund” I mean no-load open-ended mutual funds.  I’ll talk briefly about load mutual funds and closed-end mutual funds/ETFs in part III.

Here goes:

What they are: specialized corporations with a tax break

Both mutual funds and ETFs are special-purpose corporations.  Every ETF and every mutual fund has a board of directors elected by shareholders.  Each has officers, other employees and shares outstanding, the way any corporation does.  They are special in three ways:

1.  They are exempt from corporate income tax, although shareholders have to pay personal income tax on any distributions they receive.  In contrast,  “regular” corporations pay income tax on the money they earn.  In addition, if they pay a dividend to shareholders from their after-tax income, recipients are subject to personal income tax on whatever they receive.  This is called the double taxation of dividends.

In return for this benefit:

2.  ETFs and mutual funds are required to distribute each year virtually all the income they take in, both dividends and realized capital gains.

3.  Neither are allowed to operate any other businesses.  They have to restrict their activities to investing.

Mutual Funds

Buying/Selling:  done through a single distributor hired by the fund

once daily, after the US stock market close

at the fund’s net asset value (NAV), calculated as of the market close

market orders only

no short selling

Cash goes directly into the fund and is used by the fund manager to buy stocks.  Sales are met from available cash or from sale of stocks in the fund.

Trading:         frequent trading of fund shares is typically restricted, since it can disrupt the investment process

Distributions:    net  realized capital gains and dividend/interest income are distributed at least once yearly but typically more frequently for income-oriented funds

Fees/expenses:   Funds charge management fees.  Actively-managed funds may have 12b1(marketing)fees of around .25% per year; so-called “load” funds have sales charges that can be as high as 5% of the amount invested

Reporting:          Fund holdings are reported to the SEC every three months, shortly after the fiscal quarter ends.

ETFs

Buying/Selling:    traded in the open market like individual stocks

market or limit orders

short selling allowed

transactions are typically with market makers, not the fund, and need not be at NAV

Trading:     no restrictions.  If the ETF price rises above NAV, market makers can obtain new shares from the fund at NAV in exchange for baskets of stocks and offer these new shares to the market at an immediate profit.  If the price falls below NAV, market makers can reverse the process.  They buy shares in the market and redeem them at the ETF for NAV (in exchange for baskets of stocks) from the fund.  In theory, this keeps ETF values close to NAV.

Distributions:    net realized capital gains plus dividend/interest income are distributed at least once yearly but typically more frequently for income-oriented funds

Fees/expenses:  management fees are typically much less than comparable mutual funds, since market makers perform the cash to stock and stock to cash conversions.

brokerage commissions on purchase and sale

market maker spreads on transactions

Reporting:          actively-managed ETFs post their holdings on their websites and update them daily

Taxation

When you sell either ETF or mutual fund shares in a taxable account, you’ll generate a capital gain or loss unless you sell at the same net price as you bought.

If you hold the ETF or mutual fund in a taxable account on the record date for a distribution, you’ll be liable for taxes on that distribution.   This is true whether you’ve held the ETF or fund for ten years or one day.

The fact that, as a shareholder, you’re liable for tax on realized capital gains your ETF/fund distributes, whether or not you were around to enjoy the stock price rises that created those gains, was an important issue ten years ago, when most stock funds had large unrealized gains on their holdings.  Hopefully, it will be again.  But at the moment most ETFs and many mutual funds appear to have large unrealized losses, as well as unused realized losses.  Of course, you should check yourself (the information is usually at the end of the Holdings section of periodic reports as well as the prospectus) for anything you own, but capital gains distributions in the near future appear highly unlikely to me.

Practical Differences

1.  ETFs have lower management fees than traditional index funds, and have greater trading flexibility as well.  In fact, the way I read the data, broad US market EFTs have supplanted the comparable index mutual funds in the minds of the investing public over the past several years.

2.   The most important fee comparison is probably among different ETFs with the same general market coverage, rather than between ETFs and index funds.  Among broad US market choices, for example, the Vanguard index fund charges a management fee of .15% per year.  Its comparable ETF charges .07%.  In contrast, the i Share broad market ETF charges .20%.

3.  Your ability to trade ETFs is less than it might appear at first.  Suppose you want to invest $20,000 in a broad market index-tracking product.  Let’s also suppose you pick up .30% in return per year vs. an index fund, but pay a commission of $10, or .05% for every trade.  If you sell after four years, you’ve picked up  roughly 1.1% in extra return.

Both i-Share and Vanguard say that the daily last trade of their broad market ETFs almost always fall within .5% of the closing NAV.  If we take this as a first measure of intraday volatility of the ETF vs. the index, then very good trading in and out (buying under NAV and selling over NAV) could double your return advantage over a traditional index fund to 2%, while very unlucky trading could wipe out your extra gain from lower fees completely.

But this measure of volatility may not be all there is.  I’ve been trying, without success, over the past while to get data on the intraday volatility of broad market ETFs vs. their underlying index.  I don’t mean the bid-asked spread, which is very narrow.  I mean how far away from the index does the ETF price need to be for a market maker to act to fill one side or the other.  My guess is that the discount/premium to the index value when the market maker buys/sells is more than .5%, maybe 1.0%.  If that’s correct, then it would be possible to make (or lose) considerably more than I’ve outlined in the paragraph above.

This isn’t an argument against ETFs.  Quite the contrary.  I mean to say that with careful trading one might boost returns considerably.

3.  Dollar-cost averaging, a systematic savings strategy where you buy small amounts of a given fund on a regular basis, could be much more expensive with ETFs, if you will pay a commission for each purchase.

A closing thought If you’re thinking of switching from an index fund to an ETF, now may be an excellent time to do so–assuming you have a loss on the index fund and are a taxable investor.  If you have a gain on the index fund, you’ll have to pay a capital gains tax on the profits you realize when you make the switch.  That may make the switch uneconomical.  If you have a loss, however, there’s no capital gains tax.  And you can use that to offset gains on something else you might want to sell.

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