Mutual Funds

Most investors are very familiar with mutual funds. Mutual funds have been around since the 1890s, with the most common structure (open end) being established in 1924. These funds are a way for investors to access a diversified “basket” of securities. Mutual funds hold all types of assets- everything from stocks, to treasury bonds, to leveraged loans. They can be actively managed or “passively” track an index of assets. There is a mutual fund out there for just about any type or collection of assets you can imagine.

The appeal of the mutual fund structure is obvious- mutual funds are vehicles that allow everyday investors to purchase a diversified basket of assets that would be difficult to replicate on their own. In addition to this, mutual funds allow you do buy “dollar” amounts. This means you can invest, for example, a full $450 from each paycheck into one or more mutual funds. This stands in contrast with stocks, which must typically be purchased in whole shares and bonds, which are typically sold in minimum amounts of $1000.

For many years, mutual funds were extremely popular and investors poured billions of dollars a year into them. There are, however, several drawbacks to mutual funds that caused investors and investment companies to start to look for another structure to better suit their needs. Among the drawbacks to mutual funds are:

Higher Costs

Regardless of the legal structure, it costs some amount of money to operate an investment fund. Funds need to pay for managers to oversee the operation of the fund, computer systems to execute trades and redemptions, and the costs of staying legally compliant. To cover these costs, funds charge an “expense ratio.” Certain mutual funds charge fees to cover marketing costs, known as “12b-1” fees.

Investors may also pay significant fees when buying or redeeming mutual fund shares, depending on the share class. Fees due when purchasing shares, known as “front-end load” vary and can be as high as 8.5%. Fees due when shares are redeemed vary and can be 5% or more.

Across the financial services industry, people have been paying much more attention to the fees associated with investing. This has put pressure on all players in the industry from brokerages and market makers, to the investment companies operating mutual funds. While mutual fund fees have come down on average, there are still many very expensive mutual funds in operation.

Lack of Intraday Trading

Mutual fund shares cannot be traded between two individuals. When purchasing shares in a mutual fund, the cash is essentially “deposited” with the mutual fund company. The mutual fund company will purchase additional shares of stock or additional bonds and issue new shares of the fund to you. Likewise, when you “sell” mutual fund shares, the mutual fund company will sell the underlying assets attributable to your shares, then give you the cash. This is known as a redemption.

Mutual funds execute purchases and redemptions only once per day- at the end of the trading session. The price you pay for shares of the fund will always equal the value of the underlying securities, also known as the Net Asset Value (NAV). As such, mutual fund shares cannot be traded throughout the trading session.

Complexity

Mutual funds often have multiple classes of shares. The difference between the classes typically comes down to the fee structure and when those fees are paid to the mutual fund company. Certain funds charge a fee when you purchase shares (front-end load funds) or when you sell shares (back-end load funds). Other funds are no-load which means there is no fee when you buy or sell, but you must still pay the ongoing expense ratio. Furthermore, some mutual fund share classes convert to a different class if held long enough. Sorting all this out can be difficult. Zacks has a great article describing some of the differences between share classes.

Tax Inefficiency

The legal structure of mutual funds makes them relatively tax-inefficient. Because mutual funds must buy the underlying securities when investors buy shares of the fund and sell when investors sell, mutual funds are forced to pass along capital gains to shareholders. This tax inefficiency can have a major impact on after-tax returns. Importantly, if mutual funds are held in a tax-deferred retirement account such as a traditional IRA or a non-Roth 401(k), this tax inefficiency is of no consequence.

ETFs

Exchange Traded Funds (ETFs) were first created in the early 1990s. Like mutual funds, ETFs allow investors to buy a diversified basket of securities. The biggest difference between an ETF and a mutual fund is that ETFs trade like a stock. However, ETFs offer many other advantages over mutual funds including the following:

Lower Costs

ETFs got their foot in the door with investors by providing access to the same indices or securities as mutual funds at a lower cost. According to our own research using data from YCharts, the average mutual fund expense ratio stands at about 1.25% whereas ETFs’ average cost is about 0.53% per year. This may not sound like much, but it represents a 57% savings! This cost advantage has the potential to provide larger gains over time as the savings compound throughout the years.

Intraday Trading

Unlike mutual funds, ETFs can be traded between individual investors. This also means they can be traded throughout the trading session and trade execution typically happens almost instantly. This is a huge advantage over mutual funds and makes trading significantly easier for both advisors and individuals because the amount of the proceeds is known immediately, rather than after the end of the session.

Simplicity

ETFs only offer one class of shares. This means the cost of purchasing, selling, or holding shares is much easier to calculate and is lower, on average, than mutual funds. ETFs do not have 12b-1 fees or load fees. The cost of holding the shares is just the net expense ratio, which is very easily determined on most brokerages’ websites or by doing a quick Google search. Because they trade like stocks, the cost to buy or sell ETF shares is the amount of the commission charged by your brokerage. However, many brokerages have recently eliminated commissions for stocks and ETFs.

Tax Efficiency

The legal structure of ETFs allows them to avoid passing along most of the capital gains required for mutual funds holding the same securities. The mechanics that allow this tax efficiency are complicated, but suffice it to say ETFs pay out capital gains more rarely than similarly oriented mutual funds. This can be very advantageous in taxable accounts.

A key difference between Mutual funds and ETFs is that ETFs may sell above or below the NAV. This means you may pay more or less than the fair market value of the underlying securities in the fund. This may provide investors the opportunity to scoop up assets at a discount. But, by the same token, this may mean selling the fund for less than the assets are worth. Typically, the discount or premium to NAV stays very close to zero, especially with larger, more liquid ETFs. However, during very volatile markets, the discount or premium can widen. Remember- a key feature of mutual funds is that they are always purchased or redeemed exactly at NAV.

One of the few disadvantages ETFs have compared to mutual funds is that they are sold in whole shares only- through most brokerages anyway. This makes it difficult to invest smaller dollar amounts in ETFs. Most ETFs offer dividend reinvestment, so partial shares can accrue over time- it’s just purchases that must be made in whole shares. A few brokerages have rolled out the ability to purchase fractional shares which alleviates this issue, and a few others have announced plans to do so. This will eliminate this issue for investors.

Most employer sponsored retirement plans (such as 401(k)s) use only mutual funds. There are a few reasons for this. For starters, the tax efficiency offered by ETFs is inconsequential in retirement plans because they are, by nature, tax-deferred or tax-advantaged accounts. Furthermore, retirement plans are not designed to be vehicles for day trading or even frequent trading. This negates the advantage of intraday trading. Many employers give employees access to some index or target date mutual funds with very low fees which decreases costs for employees. Finally, the options are limited, so employees don’t face confusion in selecting the right mutual fund share class.

Both ETFs and mutual funds can be a great way for investors to diversify their portfolio. There are several reasons these types of funds are a great vehicle to achieve this diversification. Certain types of assets are very expensive- Amazon’s current share price is nearly $3400, for example. For many people, it’s far easier to purchase a “slice” of Amazon stock inside a mutual fund or ETF. Likewise, bonds are bought and sold in $1000 increments. Other types of assets are riskier. Purchasing emerging market bonds, for example, through the use of an ETF that owns thousands of bonds provides instant diversification which may offset some of the risks intrinsic to the asset class.

Overall, investors have been steadily pulling money out of mutual funds and putting money into ETFs over the past several years. Due to the advantages ETFs offer over similar mutual funds, there is no reason to think this trend will stop any time soon. In our firm, we maintain very few positions in mutual funds for clients and we have transitioned most of the money that was in mutual funds to ETFs. The SEC has been steadily making it easier for firms to create new ETFs and at this point, if there is a specific type of investment you’re looking for, chances are there is an ETF to suit your needs.