Mutual Funds vs Exchange Traded Funds

By Schultz Collins Investment Counsel on March 31, 2023

Mutual Funds vs Exchange Traded Funds (ETFs):  

 
Similarities, Differences & How We Help You Decide Which to Own 

Many of our client portfolios consist of mutual funds and exchange traded funds, also known as ETFs. These two investment structures have similar features yet have material differences. Today, I want to discuss their similarities, differences and why it is common for a Schultz Collins portfolio to hold both options.  

Common Features 

ETF’s and mutual funds are investment vehicles responsible for investing client dollars. To invest in each instrument, a client purchases shares. Both have an investment management team tasked with investing and managing those dollars in a well-defined group of U.S. or international stocks, bonds, or other assets.  

Mutual funds and ETF’s offer an investor the ability to invest in all major stock, bond or other asset classes including options tied to most major stock, bond, real estate and commodity indexes.  

So far, we have discussed common features of these two options; however, there are some material differences to understand.   

Trading Flexibility and When Money is Due or Available  

First, ETF’s are traded on an exchange just like individual stocks. In contrast, mutual funds are not listed or priced on a stock exchange, rather investors deal with the fund directly or through the brokerage firm holding the fund for the client. Since ETFs are transacted on an exchange, they can be bought and sold during the day when stock exchanges are open. This means investors can immediately see the price of the ETF trade. Mutual fund prices and transactions are determined at the end of each day which may be unsettling to an investor since markets can change dramatically over the course of a day! 

ETF and mutual funds have different trade settlement dates which is when the proceeds from a sale are available or when dollars are due to complete a purchase. For ETF’s, settlement is two days after the trade date while mutual fund settlement is one day after the sale or purchase.  

Tax Efficiency 

The most often cited advantage of ETF’s is the potential, but not the guarantee, of less capital gain distributions to shareholders. A mutual fund investor will redeem her shares with the fund company, directly or through a broker. The fund managers may be required to sell securities that have appreciated, generating unplanned capital gains in the fund which are distributed to all fund shareholders on a pro-rata basis. Fund managers are obviously aware of this possibility; therefore, they often utilize sophisticated and costly investment strategies to meet future redemption demands. These additional management costs are paid by the shareholders.  

If a typical ETF investor demands cash, she will sell shares on an exchange to a buyer just like a stock transaction. Selling shares of an ETF does not obligate the ETF manager to sell the underlying securities managed. In contrast to mutual funds, 100% of the tax consequences are realized by the seller and selling ETF shares does not trigger a capital gain to all shareholders.   

For large institutional ETF shareholders, a more complex redemption and creation process is used which avoids capital gain distributions. Rather than selling on an exchange, ETFs may satisfy large redemptions with shares of underlying stock in the ETF. The shares of the underlying stocks are given to the redeemer and the fund does not realize a capital gain from the redemption. It should be noted that both ETFs and funds have a similar institutional redemption process, but this type of transaction is more prevalent with institutional shareholders of ETF’s than mutual funds. 

Does this mean we should assume all ETF’s will have a lower tax bite compared to mutual funds? No. The underlying investment strategy, even an index strategy, may generate normal management activity by ETF managers that results in capital gain distributions, as is the case with a mutual fund.  

Operating, Transaction or Commission Costs 

Due to previously described cost of management, mutual funds may have marginally higher management fees when compared to its ETF counterpart. For example, a mutual fund may have an expense ratio of 0.07% but the ETF alternative with the same strategy may have an expense ratio of 0.04%. However, clients should not assume all ETFs are cheaper than all mutual funds. There are plenty of examples of ETF’s with high or above average expense ratios.  

In addition to operating or management costs, mutual fund and ETF trades may also have a commission or transaction costs determined by the fee schedule of a brokerage firm or the fund. Most brokerage firms allow investors and advisors to buy many no-commission, or no-load, mutual funds and ETF’s for free or charge a nominal transaction fee of $4 to $50. Mutual Fund investors can avoid these transaction costs by investing directly with the fund company, which is not possible with ETFs. One disadvantage of mutual funds is a potential commission charge of 5% or more. No such commission charges are known to be connected to the purchase or sale of an ETF. Only broker transaction fees need be paid.  

Should we always invest in ETFs’? 

It seems logical that some investors may ask, “Shouldn’t we always invest in ETF’s?” During the portfolio construction and supervision process, the Schultz Collins advisor and advisory team evaluate the ETF or mutual fund’s:  

1. Underlying strategy and its ability to capture returns in 1 of 15 different asset classes  

2. Ability to enhance the risk and return characteristics of portfolio  

3. Historic or potential tax liabilities  

4. Transaction and operational costs  

5. Ability to meet client preferences.  

As always, diversification is the goal. Accomplishing this goal may require investing in different underlying investment strategies across asset classes, but may only be possible by investing in a mutual fund, or a mutual fund and an ETF. If additional costs are required to do so, then it is the advisor’s fiduciary duty to determine if the additional costs are justified.  

For example, an advisor seeking to allocate a portion of a client’s assets in the U.S. Large Cap Value stock asset class may conclude desirable risk and return trade-offs and benefits of diversification are best accomplished by owning an ETF with strategy A with operating costs of 0.07%; plus, a mutual fund with strategy B that has operating costs of 0.28%.     

As you can see, there are reasons for investors and advisors to favor ETF’s over mutual funds: possible lower operating costs and capital gain taxes, plus greater control of execution prices are all attractive. However, this is not always the case and further analysis is required to make a prudent decision. Despite potential lower overall costs, there may be times when an ETF may not provide the most benefits to a portfolio and may not meet the client’s needs and preferences and that is where the advisor and advisory team can help.  

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Disclaimer: Schultz Collins is a group comprised of investment professionals registered with Hightower Advisors, LLC, an SEC registered investment adviser. Some investment professionals may also be registered with Hightower Securities, LLC, member FINRA and SIPC. Advisory services are offered through Hightower Advisors, LLC. Securities are offered through Hightower Securities, LLC.  

This is not an offer to buy or sell securities. No investment process is free of risk, and there is no guarantee that the investment process or the investment opportunities referenced herein will be profitable. Past performance is neither indicative nor a guarantee of future results. The investment opportunities referenced herein may not be suitable for all investors.  

All data or other information referenced herein is from sources believed to be reliable. Any opinions, news, research, analyses, prices, or other data or information contained in this presentation is provided as general market commentary and does not constitute investment advice. Schultz Collins and Hightower Advisors, LLC or any of its affiliates make no representations or warranties express or implied as to the accuracy or completeness of the information, or for statements or errors or omissions, or results obtained from the use of this information. Schultz Collins and Hightower Advisors, LLC assume no liability for any action made or taken in reliance on or relating in any way to this information. The information is provided as of the date referenced in the document. Such data and other information are subject to change without notice.  

This document was created for informational purposes only; the opinions expressed herein are solely those of the author(s) and do not represent those of Hightower Advisors, LLC, or any of its affiliates.