Understanding the Jargon: Mutual Funds vs. ETFs

Understanding the Jargon: Mutual Funds vs. ETFs

December 17, 2020
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It is not difficult to see why so many people have not started investing or planning for their future. With a myriad of financial terms, products, and companies, one can easily become overwhelmed and suffer from “analysis paralysis”. This is yet another example of an area where the financial advice industry has failed the public. But the good news is that, by taking it one step at a time, financial planning does not have to be overly complex and intimidating. With that in mind I will be dedicating the next several weeks of this blog to explaining a number of different financial terms, products, and other jargon. This week, we are going to examine two of the most used terms in consumer finance: Mutual Funds and Exchange Traded Funds (ETFs).

                If you have ever had a 401(k), IRA or other such investment account, you have no doubt encountered the terms mutual fund or ETF. Both types of funds are created by investment managers who pick and choose stocks, bonds, and alternative investments in order to reach a stated investment goal. For example, ABC Investment Company might offer a fund called the U.S. Large Cap Growth fund. The managers of that fund would seek to purchase stock in large U.S. companies with the potential for stable long-term goal. As an investor, you would have the opportunity to invest in that fund and participate in the growth and performance of the fund managers. By doing so, you are also investing your money in a portfolio of many different companies as opposed to picking stocks on your own. This does not come without a cost as both mutual funds and ETFs charge an internal fee referred to as an expense ratio. Some mutual funds also charge a commission to purchase the fund in the first place called a sales charge or load. Overall, mutual funds and ETFs share the same attributes of diversification, professional management, and accessibility for consumers. However, there are a number of ways in which they differ.

                Mutual funds are not a new idea and have been around since the 1920s. They were created to solve a problem in area of consumer finance. Many individuals and smaller clients wanted to invest in the markets but did not have the knowledge, time, or confidence to buy and sell stocks on their own and certainly didn’t have the money to purchase shares of many different companies. Mutual funds addressed this problem by creating a pool of investor’s money and investing it in a professionally managed portfolio. This gave smaller or inexperienced investors access to professional money managers in a way that hadn’t existed in the past.

                Today, mutual funds are the quintessential investment of choice for many corporate retirement plans and individual retirement accounts. Many financial advisors (ourselves included) have also shifted away from buying individual stocks and bonds for their clients and prefer to rely on building portfolios of mutual funds in order to satisfy their client’s investment needs. In practice, mutual funds are quite easy to invest in although they often have a minimum initial investment to get started. Mutual funds can be purchased any time during trading hours (9:30-4:00 EST) but the trade itself is not actually made until the markets close for the day. The price that you pay for a share of a mutual fund is based off the value of the fund at market close the day before. This price is called the fund’s net asset value or NAV. The fund’s value is calculated in this way because of the many companies that they own and their shifting prices throughout the day. It is far easier from an administrative standpoint for a fund to determine its value at the end of the day rather than trying to keep up with the individual prices of its entire portfolio of stocks and bonds.

                Exchange traded funds or ETFs are very similar to mutual funds with a few key differences. The first ETF was created in the 1990s as a more flexible, low-cost alternative to the mutual fund. Unlike mutual funds, ETFs are traded intraday like any other stock or bond which means the price you see is what you get. One reason for this difference is that shares of ETFs can actually be traded between investors on the open market. Shares of mutual funds on the other hand can normally only be redeemed with the mutual fund company itself. Think of it this way, when you invest in a mutual fund, you are investing your money in a portfolio with a team of professionals managing it. When you invest in an ETF, you are essentially purchasing shares in a company whose value is derived from the management of a fund.

                The other key difference between a mutual fund and an ETF is the way in which the funds are managed. Usually, mutual funds utilize what we call, “active management”. This means that the managers of the fund are actively trading the portfolio in order to meet their investment objectives and, in many cases, attempting to perform better than the overall market or relative index. In most cases, ETFs utilize “passive management”. Managers of ETFs do not actively trade the fund to strategically navigate the ups and downs in the market. Rather, they choose an index (the S&P 500 for example) and simply purchase all of the holdings in that index. The only trading that occurs in a passively managed ETF is what is necessary to ensure that the fund still conforms to the index that it is tracking. Because of the lack of active management in an ETF, the expense ratio is often much lower than that of a mutual fund. Many investors have flocked to ETFs due to the lower expense and the belief that it is extremely difficult, maybe even impossible to beat the market consistently. However, there are many mutual funds who have a long track record of outperformance so this statement should be taken with a grain of salt. I wrote a blog post on active vs. passive (or indexed) fund management which you can read here.

 

                Hopefully today’s blog posts proves to be a valuable resource for you! As I mentioned, I intend to do several more posts like this in the coming weeks. Let me know if there is a term or idea that you would like to understand better and I will include it in an upcoming blog post. Also, I did want to acknowledge that I have yet again failed at my goal of publishing this blog once a week. Rest assured I will endeavor to do better in the new year!