Friday, October 12, 2012

ETFs vs. Mutual Funds and What's Best?

Although ETFs aren’t even 20 years old, they have become a force to be reckoned with in the investment world. Assets under management for the industry are now well over one trillion dollars and new products are debuting on a nearly weekly basis.

Funds now allow investors to purchase pretty much anything ranging from large cap U.S. stocks to German bonds, equities in Thailand, commodities, and everything in between. Yet despite the fact that ETFs are going increasingly mainstream, there are still several misconceptions about the product and especially how they relate to their chief rival, mutual funds.

Mutual Funds are more established than their ETF counterparts and have been around a lot longer too. In fact, mutual funds can trace their roots back to the 18th century although the first true American open-ended mutual fund debuted in the mid 1920’s.

After surviving the Great Depression, mutual funds took off after World War Two becoming one of the go-to investments for the American public. Currently, there are close to 7,600 mutual funds in the U.S. with assets under management over $11 trillion. The product now dominates the lucrative retirement market and is still a force in other types of accounts as well.

With both product types now exceeding at least $1 trillion in assets and 1,000 total funds, the debate is beginning to intensify over which is more appropriate for investors’ portfolios. While there are a number of structural differences between the two products and how they are created, we have highlighted some of the most important facts that investors must remember when deciding between the two products for their portfolio.

In many ways, ETFs took the concept of a mutual fund and improved on it. There are many ways in which ETFs have revolutionized the investment world and opened up a variety of asset classes in a fashion that mutual funds have never done.

Thanks to this, the products have becoming extremely popular for both short-term traders as well as those seeking to build a long-term buy-and-hold portfolio. Below, we highlight five reasons why ETFs are better than mutual funds from a structural standpoint:

1. Intra-Day Trading - Arguably the single biggest difference between ETFs and mutual funds is on the trading front. Mutual funds, no matter when one calls up their broker to sell or buy, are only traded at the end of the day and never during market hours.

Basically, at the end of a trading session, a mutual fund company will determine the net asset value (NAV) of all the securities in its fund, divide by the total number of shares outstanding, and then use this figure to payout investors who are leaving the fund and charge investors who are adding the product to their portfolio. This is only done once a day and anyone that misses the cutoff must wait until the end of the next trading period in order to redeem or obtain shares (also read Alternative ETF Weighting Methodologies 101).

ETF investors, on the other hand, face no such restrictions and can buy and sell shares of a fund just like they would a regular stock. This means that investors can purchase and sell an ETF in the same day, buy more if prices fall or sell if the value rises in a short period of time. Obviously, this flexibility is a great feature for ETFs and can come in handy when markets are oscillating wildly and investors want to get in or out of an investment in a very short period of time.

2. Expenses - Beyond trading differences, the next biggest variation between the two comes on the expense front. On average, mutual funds change investors a little over 1% for their services while ETFs have an average about half of that. Furthermore, several exchange-traded funds charge investors less than 25 basis points a year in fees while a few broad stock market ETFs charge less than ten basis points for their services.

In fact, it is very possible to build a well-diversified portfolio with assets in all the major classes, that has an expense ratio below 20 basis points a year by only using ETFs. This is pretty much impossible from a mutual fund standpoint unless one only uses Vanguard funds. This is largely due to the structure of these products and their index following nature, they are the only type of mutual fund that can rival ETFs on an expense front, admittedly beating them out in most cases.

However, beyond this exception, all of the ten most popular mutual funds have expenses in excess of 70 basis points with most coming in close to 1%. This can often go even higher for funds that are targeting more obscure sectors or those that employ a more actively-trading methodology.

While this wouldn’t be too bad if active managers demonstrated value, a recent study suggested that close to two-thirds of actively managed mutual funds underperform the market. So not only are investors paying more in fees for mutual funds, but they are often underperforming index-based ETFs anyway, suggesting that most would be better off in exchange-traded funds for the vast majority of their exposure.

3. Disclosure requirements - Another key difference between mutual funds and ETFs has to do with the underlying holdings of the funds and how often information is released regarding this data. ETFs are required to disclose, on a daily basis, what their portfolio of securities is made up of and what proportions are in each asset.

This allows investors to know if a particular fund is matching up with their expectations making comparisons that much easier. It also gives investors a chance to see when trades were made (in active funds) and how far securities have deviated from their initial weighting (in index products), allowing investors to have valuable information about their potential or current investments.

Mutual funds, on the other hand, are only required to disclose their positions on a quarterly basis, a much less rigorous requirement. This can allow for all sorts of moves and changes in between the disclosure dates potentially giving managers the opportunity to rapidly adjust a portfolio right before the day of disclosure in order to make the basket of securities look more favorable.

Given how rocky markets have been and how quickly some assets are gaining and losing values, a quarterly update probably isn’t enough for most investors suggesting that for those looking to keep a truly watchful eye on their investments, ETFs are again the way to go.

4. Taxes - Staying in control of tax liabilities is an issue that is often at the forefront of investors’ minds but is something that many often overlook when deciding between an ETF and a mutual fund. That is because many might assume that these two products would incur identical tax liabilities although that may not always be the case.

That is because of how mutual funds and ETFs are structured and how this difference can impact tax liabilities on a yearly basis. Most mutual funds are structured as pools of assets and each investor has a share in the pool. When more assets come in, the mutual fund company must buy up more shares of stock while the opposite situation takes place when investors cash out of the fund.

This is generally different from most ETFs as these products do not usually have the same pooling feature. Instead, when a person buys an ETF they are just purchasing a basket from another investor, no shares in the underlying securities are bought or sold.

Additionally, when big investors create a new group of shares in an ETF or cash out of a large position in an exchange traded product, this doesn’t generate any transaction events either. This is because ‘authorized participants’ simply exchange the shares of their ETF for the underlying securities in what is known as an ‘in-kind’ exchange, a situation that doesn’t generate any taxable events.

While this might seem like a minor and extremely technical detail, it can have huge tax consequences. This is because when someone in a mutual fund cashes out, the underlying shares can be sold in order to raise the necessary money for the redemption. This ensures that everyone in the pool—because everyone owns a little piece of every holding—can be hit with a taxable capital gains distribution, even if they did not sell any shares that year. ETFs, on the other hand, do not usually have these issues of capital gains being spread across investors because transactions are between two individuals or institutions; no shares need to be bought or sold and thus they do not generate capital gains for the other investors in the ETF.

This allows investors to keep better track of their tax liabilities and to have more control over them as well. While this might seem like a minor issue, it is an important one nonetheless that investors need to be aware of before choosing between the two product types (also read ETFs vs. ETNs: What's The Difference?).

5. Options - Lastly, and probably the least important to long-term buy-and-hold investors, is the ability to use options on ETFs. These securities give investors the right, but not the obligation, to buy (or sell) an ETF at a future time period after paying (or obtaining) a premium from investors. While they are probably not used very often by long-term investors, these securities have valuable abilities that can help many with their portfolios.

Probably most important is the ability to hedge against losses although speculation and bets on sideways movements are also helpful. In this way, investors can control a greater amount of securities for a small price, increasing leverage but allowing a trader to deploy capital elsewhere in the meantime. Since mutual funds do not trade intra-day, they do not have this feature, forcing investors who want to use options as a part of a strategy to look at the equity or ETF markets instead (see more in the Zacks ETF Center).

Although ETFs may be leading the way in a number of key areas, mutual funds aren’t going away anytime soon. This is because of a few factors that keep mutual funds, despite their drawbacks, in the spotlight and a favorite among many investors. Below, we highlight three areas where mutual funds still have ETFs beat:

1. Active Management - Although there are a few active ETFs, for investors seeking the watchful eye of a portfolio manager mutual funds are still tough to beat. The active funds seek to weed out the securities that are mostly likely to underperform and only invest in top performing assets. While this may not be very helpful in widely traded and heavily watched spaces such as the U.S. Treasury bond market or mega cap stocks, it can produce value in more obscure sectors.

These can include high yield bonds or small cap equities where there is an overabundance of options and few analysts following the many choices. This can potentially allow managers to outperform a benchmark suggesting that, in some cases, an active touch may be better.

While it should be noted that there are a few active ETFs, there isn’t exactly a wealth of choices; by pretty much any definition there are less than 30 active funds on the market, at time of writing. Furthermore, many of these actively-managed ETFs have very low trading volumes which can result in wide bid/ask spreads, a factor that could add to total costs for investors.

So for investors seeking to have someone managing their investments and for those who do not trust products that just track a benchmark, mutual funds are probably the better choice at this juncture.

2. 401 (k) plans/ retirement accounts - The way in which most Americans have exposure to mutual funds is via their retirement savings, usually in some-sort of employee sponsored account. Since mutual funds have been around for so long and since they are often sponsored by giant financial companies such as Fidelity or Franklin Templeton, the fund sponsors have developed an administrative network to sell their funds to companies and their employees, often times consisting of only their funds.

Since this has been going on for quite some time and because these firms are firmly entrenched in their positions due to high switching costs and lack of administrative support from ETF providers, a great deal of retirement assets are in mutual funds (see Understanding Leveraged ETFs).

So in other words, if an investor is seeking to find a new product for their retirement fund, chances are ETFs will be off-limits, greatly limiting the appeal of this product for many investors. However, it should be noted that this is starting to change with the advent of commission-free trading across a number of discount-brokerage platforms. This is a good start to unseating mutual funds in the realm of retirement accounts but much more will have to be done in order to truly slice into their lead.

3. NAV Purchases - Although intra-day trading is certainly a nice feature of ETFs, there are times when it is disadvantageous. For example, if your ETF is trading at a discount to its net asset value (NAV) but you want to sell right now, you are out of luck and must take a hit in terms of return. Mutual funds are instead required by law to redeem shares at net asset value at the end of a particular trading day. A similar issue can also arise in terms of the bid/ask spread as well.

For ETFs, there is a buyer and a seller and these two individuals will have different prices for which they are willing to trade their shares. When a market is very liquid, this can be an extremely small figure, often times as little as a penny. Yet when a particular ETF doesn’t have high trading volumes, the spread between the bid and the ask can be significant and can result in a worse price for investors.

Once again, mutual funds do not have to deal with this issue because there is no bid or ask; what an investor receives is what the NAV is at the end of that day’s trading session, ensuring that mutual fund investors do not have this issue to worry about.

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