Mutual Fund vs. ETF: What’s the Difference?

Mutual Fund vs. ETF: An Overview

Mutual funds and exchange-traded funds (ETFs) have a lot in common. Both types of funds consist of a mix of many different assets and represent a popular way for investors to diversify. While mutual funds and ETFs are similar in many respects, they also have some key differences. A major difference between the two is that ETFs can be traded intra-day like stocks, while mutual funds only can be purchased at the end of each trading day based on a calculated price known as the net asset value.

Mutual funds in their present form have been around for almost a century, with the first mutual fund launched in 1924. Exchange-traded funds are relatively new entrants in the investment arena, with the first ETF launched in January 1993; this was the SPDR S&P 500 ETF Trust (SPY).

In past years, most mutual funds were actively managed, meaning fund managers made decisions about how to allocate assets in the fund, while ETFs were generally passively managed and tracked market indices or specific sector indices. That distinction has become blurred in recent years, as passive index funds make up a significant proportion of mutual funds’ assets under management, while there is a growing range of actively-managed ETFs available to investors.

Mutual Funds

Mutual funds typically come with a higher minimum investment requirement than ETFs. Those minimums can vary depending on the type of fund and company. For example, the Vanguard 500 Index Investor Fund Admiral Shares requires a $3,000 minimum investment, while The Growth Fund of America offered by American Funds requires a $250 initial deposit.

Many mutual funds are actively managed by a fund manager or team making decisions to buy and sell stocks or other securities within that fund in order to beat the market and help their investors profit. These funds usually come at a higher cost since they require substantially more time, effort, and manpower for research and analysis of securities.

Purchases and sales of mutual funds take place directly between investors and the fund. The price of the fund is not determined until the end of the business day when net asset value (NAV) is determined.

2 Kinds of Mutual Funds

There are two legal classifications for mutual funds:

• Open-Ended Funds. These funds dominate the mutual fund marketplace in volume and assets under management. With open-ended funds, the purchase and sale of fund shares take place directly between investors and the fund company. There’s no limit to the number of shares the fund can issue. So, as more investors buy into the fund, more shares are issued. Federal regulations require a daily valuation process, called marking to market, which subsequently adjusts the fund’s per-share price to reflect changes in portfolio (asset) value. The value of an individual’s shares is not affected by the number of shares outstanding.
• Closed-End Funds. These funds issue only a specific number of shares and do not issue new shares as investor demand grows. Prices are not determined by the net asset value (NAV) of the fund but are driven by investor demand. Purchases of shares are often made at a premium or discount to NAV.

Exchange-Traded Funds (ETFs)

ETFs can cost far less for an entry position—as little as the cost of one share, plus fees or commissions. An ETF is created or redeemed in large lots by institutional investors and the shares trade throughout the day between investors like a stock. Like a stock, ETFs can be sold short. Those provisions are important to traders and speculators, but of little interest to long-term investors. But because ETFs are priced continuously by the market, there is the potential for trading to take place at a price other than the true NAV, which may introduce the opportunity for arbitrage.

ETFs offer tax advantages to investors. As passively managed portfolios, ETFs (and index funds) tend to realize fewer capital gains than actively managed mutual funds.

ETF Creation and Redemption

The creation/redemption process of ETFs distinguishes them from other investment vehicles and provides a number of benefits. Creation involves buying all the underlying securities that constitute the ETF and bundling them into the ETF structure. Redemption involves “unbundling” the ETF back into its individual securities.

The ETF creation and redemption process occurs in the primary market between the ETF sponsor – the ETF issuer and fund manager that administers and markets the ETF – and authorized participants (APs), who are US-registered broker-dealers that have the right to create and redeem shares of an ETF. The APs assemble the securities included in the ETF in their correct weights and deliver those securities to the ETF sponsor.

For example, an S&P 500 ETF would require the APs to create ETF shares by assembling all the S&P 500 constituent stocks – based on their weights in the S&P 500 index – and delivering them to the ETF sponsor. The ETF sponsor then bundles these securities into the ETF wrapper and delivers the ETF shares to the APs. ETF share creation is generally in large increments, such as 50,000 shares. The new ETF shares are then listed on the secondary market, and trade on an exchange, just like stocks.

With an ETF redemption, the process is the opposite of ETF creation. APs aggregate ETF shares known as redemption units in the secondary market and deliver them to the ETF sponsor in exchange for the underlying securities of the ETF.

ETF Benefits

The unique ETF creation/redemption process results in ETF prices tracking their net asset value closely, since the APs monitor demand for an ETF closely and act promptly to reduce significant premiums or discounts to the ETF’s NAV.

The creation/redemption process also means that the ETF’s fund manager does not need to buy or sell the ETF’s underlying securities except when the ETF portfolio has to be rebalanced. Since an ETF redemption is an “in kind” transaction as it involves ETF shares being exchanged for the underlying securities, it is typically tax-exempt and makes ETFs more tax efficient.

Thus, while the process of creating and redeeming shares of a mutual fund can trigger capital gains tax liabilities for all shareholders of the mutual fund, this is less likely to occur for ETF shareholders who are not trading shares. Note that the ETF shareholder is still on the hook for capital gains tax when the ETF shares are sold; however, the investor can choose the timing of such a sale.

3 Structures of ETFs

There are three structures of ETFs:

• Exchange-Traded Open-End Fund: The vast majority of ETFs are registered under the SEC’s Investment Company Act of 1940 as open-end management companies. This ETF structure has specific diversification requirements, as for example, no more than 5% of the portfolio can be invested in securities of a single stock. This structure also offers greater portfolio management flexibility compared to the Unit Investment Trust structure, as it is not required to fully replicate an index. Therefore, a number of open-end ETFs use optimization or sampling strategies to replicate an index and match its characteristics, rather than owning every single constituent security in the index. Open-end funds are also permitted to reinvest dividends in additional securities until distributions are made to shareholders. Securities lending is allowed and derivatives may be used in the fund.
• Exchange-Traded Unit Investment Trust (UIT). Exchange-traded UITs also are governed by the Investment Company Act of 1940, but these must attempt to fully replicate their specific indexes to limit tracking error, limit investments in a single issue to 25% or less, and set additional weighting limits for diversified and non-diversified funds. The first ETFs, such as the SPDR S&P 500 ETF, were structured as UITs. UITs do not automatically reinvest dividends but pay cash dividends quarterly. They are not allowed to engage in securities lending or hold derivatives. Some examples of this structure include the QQQQ and Dow DIAMONDS (DIA).
• Exchange-Traded Grantor Trust. This is the preferred structure for ETFs that invest in commodities. Such ETFs are structured as grantor trusts, which are registered under the Securities Act of 1933, but not registered under the Investment Company Act of 1940. This type of ETF bears a strong resemblance to a closed-ended fund, but an investor owns the underlying shares in the companies in which the ETF is invested. This includes having the voting rights associated with being a shareholder. The composition of the fund does not change, though. Dividends are not reinvested, but they are paid directly to shareholders. Investors must trade in 100-share lots. Holding company depository receipts (HOLDRs) is one example of this type of ETF.

Mutual Fund vs. ETF Redemption Example

For example, suppose an investor redeems $50,000 from a traditional Standard & Poor’s 500 Index (S&P 500) fund. To pay the investor, the fund must sell $50,000 worth of stock. If appreciated stocks are sold to free up the cash for the investor, the fund captures that capital gain, which is distributed to shareholders before year-end.

As a result, shareholders pay the taxes for the turnover within the fund. If an ETF shareholder wishes to redeem $50,000, the ETF doesn’t sell any stock in the portfolio. Instead, it offers shareholders “in-kind redemptions,” which limit the possibility of paying capital gains.