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ETFs vs. Mutual Funds: What's the difference?
Are Exchange-Traded Funds and Mutual Funds the same thing? Not exactly. Here are some key things any beginner investor should know about these popular investments.
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When you're just starting out as an investor, there are so many acronyms, account types and investments to learn, it can feel like a game of carnival whack-a-mole: You learn one new thing only to have two more questions arise. One topic that pops up often for new and novice investors? The difference between ETFs (Exchange-Traded Funds) and Mutual Funds.
Fortunately, the differences between these two popular types of investment products can be explained. And frankly, both types of products can help you reach your investment goals. Surely a comfortable retirement, a down payment for a home or a slick new reno is a more useful prize than a supersized stuffy. So let's put the mallet aside and take a moment to consider some of the key similarities — and differences — between ETFs and Mutual Funds, along with some of the reasons investors might choose them.
What are ETFs and Mutual Funds?
They are two kinds of investment products that share several similarities. Both ETFs and Mutual Funds offer a way for investors to pool money into a fund that make investments in a collection of stocks, bonds, or other assets. In exchange, investors receive a share of that investment pool, in the form of unit(s) of the fund or ETF. Both types of products are immensely popular with investors. According to the Investment Funds Institute of Canada (IFIC), which releases an annual report of Mutual Fund and ETF sales each year, Canadians had a total of $2.08 trillion invested in Mutual Funds at the end of 2021, and $347 billion invested in ETFs. Over the previous decade, the value of Canadian Mutual Fund assets has grown by more than 2.5 times — through a combination of both new sales and market growth. For ETFs, the total Canadian value grew by more than 8 times, through new sales and market growth. Here are some other ways ETFs and Mutual Funds are similar:
- They can both be held inside a Tax-Free Savings Account (TFSA) or Registered Retirement Savings Account (RRSP). Non-registered accounts too. By making regular contributions to your investments in these accounts, you can take advantage of compounding interest to grow your wealth.
- They both can add instant diversification to a portfolio. The funds often hold a spectrum of investments, as opposed to a single stock or security, which lowers the risk that a single investment can tank your whole investment strategy.
- They both offer variations to match your risk profile. The companies that assemble and manage ETFs and Mutual Funds can tailor the funds to hold a heavier mix of equities and higher risk securities for more aggressive investors, or a greater mix of lower risk investments such as bonds and cash for more conservative investors.
Ultimately ETFs and Mutual Funds can make money for investors in two very similar ways. The first is from capital gains, which is the increase in asset value of the investments themselves. The other is from distributions. Depending on the fund you choose, you may get annual distributions of dividends, interest, or other income from the investments. We won't talk about that here. For now, let's look at some of the major ways ETFs and Mutual Funds differ.
ETFs and Mutual Funds get bought and sold at different times
One of the ways ETFs and Mutual Funds differ is how they are priced and sold. ETFs trade in real-time on an exchange (like the Toronto Stock Exchange) and can be purchased at any time throughout the trading day through any brokerage account. In contrast, Mutual Funds orders are aggregated throughout the day by the fund provider and executed only once, at the end of the day, based on market close prices.
ETFs and Mutual Funds have different costs to consider
Another way ETFs and Mutual Funds differ are in their management fees and operating expenses. You don't pay these fees directly; they get paid by the fund itself and are expressed as a percentage of the total value of the fund (it can be a range of less than 1% to more than 3%). The management expense ratio (MER), is often lower for an ETF because many ETFs are not "actively managed," meaning that their underlying investments are not selected based on a manager's outlook or assessment of these securities, but instead are selected so as to best track a benchmark, such as the S&P 500 or the S&P/TSX index.
The MER for a Mutual Fund may also include something called a trailing commission, paid each year to your advisor's firm to cover the cost of the services you receive from an advisor.
As of June 1, 2022, the Canadian Securities Administrators have ruled that trailing commissions may no longer be included in the sale of mutual funds and ETFs held in self-directed accounts. Mutual Funds and ETFs that contain so-called trailer fees are no longer available to self-directed investors (DIY investors) using a brokerage account.
Mutual Funds trade at their Net Asset Value (NAV), while ETFs trade at the prevailing market price at the time of execution. This price may be slightly higher or lower than the underlying NAV and should be factored into the total cost of ownership of an ETF. Other ETF costs include trading commissions, trading spreads and the cost of owning a brokerage account.
Key Differences: ETFs vs Mutual Funds
ETFs |
Mutual Funds |
|
Trading and Pricing |
Trade on stock exchanges like individual stocks at the prevailing market price at the time of execution. Their prices fluctuate throughout the trading day based on supply and demand. |
Orders can be placed throughout the day, but they are filled only at the end of the trading day at the fund’s net asset value (NAV) price. |
Management Style |
Typically, passively managed, tracking an index such as the S&P/TSX Composite Index. However, there are also actively managed ETFs. |
Often actively managed, which means fund managers make decisions about how to allocate assets in the fund. There are also passively managed mutual funds that track indexes. |
Costs and Fees |
Generally, they have lower management expense ratio (MER) compared to mutual funds due to their passive management. May also be subject to trading fees like stocks. |
Can have higher fees due to active management, including costs for research and administration. Some mutual funds may have no load, front-end load or back-end load fee. |
Flexibility |
Offer more flexibility as they can be traded throughout the day and are considered more liquid. |
Transactions are processed once per day after the market closes. |
Why people choose to invest in ETFs
There are several reasons investors can choose to invest in ETFs to help reach their investing goals. Because ETFs are purchased and sold throughout the day on an exchange, they offer a great amount of flexibility for investors, and are uniquely suitable for those who enjoy the responsibility of managing their own investments. Here are some more reasons some investors choose ETFs:
- ETFs can be a good way to add diversification to a portfolio
- The prices for ETFs change minute- by minute, making them suitable for day traders as well as long-term investor
- ETFs tend to have lower fees and no minimum investment, making them a low-cost alternative for many portfolios. However, investors should be mindful of trading commissions and trading costs (bid-ask spreads) that may result from the frequent trading of ETFs, and could potentially eat away at returns.
- ETFs tend to be more transparent in their disclosure of holdings. Many ETF issuers provide the full list of underlying holdings on their website.
Why people choose to invest in Mutual Funds
There are also several reasons investors may choose to invest in Mutual Funds to help reach their investing goals. One key reason is that they can be simple to manage in a hands-off way, particularly if you're working with an advisor. Here are some more reasons investors choose Mutual Funds:
- Mutual Funds are often designed for long-term investors and their fee structure (which may include an Early Redemption Fee) further encourages investors to stay invested, even during challenging market conditions.
- Mutual Funds may be well-suited to people who prefer their portfolio to be professionally managed
- Mutual Funds can be easily incorporated into a set-it-and-forget-it automatic contribution program
In the end, whether you choose to invest in ETFs or Mutual Funds — or both — is up to you and your investing style. Both ETFs and Mutual Funds can be an effective part of any portfolio, whether you are trading daily or executing a long-term buy-and-hold strategy.
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