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Are ETFs (Exchange Traded Funds) Better than Mutual Funds?

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Read a financial advice column and chances are good it will say: “Don’t buy mutual funds, buy ETFs. They’re way better.” But why are ETFs better? And is it even true or is it just hype? Let’s compare ETFs and mutual funds.

What Do ETFs Invest In?

As described in What Is an ETF?, ETFs invest a pool of money just like mutual funds. Often the capital is invested in the shares of multiple companies but the ETF can also buy other investments like bonds, precious metals, and commercial paper.

Both mutual funds and ETFs offer very similar holdings. For example, if you want a fund (they are both funds, remember) that holds 1-5 year corporate bonds you can probably find both an ETF and a mutual fund that meet your requirements. An example would be the iShares 1-5 Year Laddered Corporate Bond Index Fund ETF (CBO) and the BMO Laddered Corporate Bond Fund.

Are All ETFs Index Dependent?

Many financial articles talk about ETF index funds. In particular, many writers believe that the best returns are earned by buying an investment that replicates all or most of a stock market index. Investing in this way avoids problems with market timing. It’s based on the theory that over time, markets rise, even if they rollercoaster along the journey.

The first heavily-promoted ETFs were index funds. The ETF would replicate, for example, the S&P TSX Composite Index by investing in stocks that matched the holdings and percentages of the companies listed on the Composite. If the composite went up, so did the value of the ETF. If the composite slid, so did the value of the ETF.

Now there are ETFs that offer to let you invest in just about anything. Although index-linked ETFs are still the most common, not all ETFs are index based.

There are also ETFs that claim to follow an index, but the index was created just to claim an ETF mirrors it, or the index exists but is very obscure and tracks only a very small portion of the stock market. For example, did you know there is a Dow Jones US Select Medical Equipment Index? Well there is, and there’s an ETF that let’s you invest in it. Why you would want to is another question.

When financial pundits recommend index investing, they are not usually talking about these small, specialized obscure indices.

There were and are also mutual funds that track indices, both large entire-market indices and small, obscure indices.

So both ETFs and mutual funds allow investors to mirror indices.

How ETFs and Mutual Funds are Priced

One fundamental difference between ETFs and Mutual Funds is how they are priced.
Mutual funds have a price that is set at the end of each business day. The value of the holdings of the fund is added up, any costs from that day are subtracted, and the balance is divided by the number of units of the fund. That determines the daily price at the close of the markets. This is called the NAV or Net Asset Value per unit.

When you buy a mutual fund, you pay the NAV. Since the NAV is not calculated until the end of the day, you do not know exactly what price you are paying for the fund until after you’ve bought it. Instead, you enter an order to purchase a dollar amount of a fund. For example, you place an order to buy $250 of the TD Advantage Balanced Income Portfolio fund. The next day, you’ll find out how many units of the fund you bought.

Similarly, when you sell a mutual fund you enter an order to sell a certain number of units. You won’t know until after the markets close and your order is settled how much money you are getting! It depends on whether the NAV went up or down that day.

ETFs are handled differently. An ETF is basically a mutual fund that is sold on the stock exchange. Just like a corporation has an asset value which should determine the value of its shares, an ETF has financial holdings that should determine the value of its units. But just like with company shares, the actual sale value of an ETF unit floats up and down based on demand as well as on intrinsic value. From what I’ve read, the actual sale value stays tightly close to the intrinisic value because of the way they are managed.

Customers Can Control the Price for Purchases and Sales of ETFs but Not of Mutual Funds

An ETF can be purchased at any time during the trading day. The value will flutter up and down based on the number of requests to buy units and the number of requests to sell units and on the changes in the values of the underlying companies’ shares.

When buying an ETF, a customer can set a limit on how much he is willing to pay per unit. Similarly, when selling an ETF, a customer can set a limit on what price will be acceptable.

This is quite different than with mutual funds. You cannot, generally, control the price you will pay or accept when buying a mutual fund.

Customers Pay Commissions When Buying and Selling Some ETFs and Some Mutual Funds

Fees are always murky.

ETF Purchase and Sale Commissions

In the first days of ETFs, customers always paid a trading commission on each purchase or sale of units of an ETF. The trades were basically the same as an equity (or share) trade. So at a self directed brokerage, a customer would usually pay $4.95-$40 to purchase or sell units of an ETF.

The commission that must be paid each time a unit or units of an ETF are purchased or sold is a deterrent to ownership and to investors who wish to contribute small amounts regularly to their savings. Some of these investors may choose no-load mutual funds instead. Then they can buy small amounts of the mutual fund on a regular basis without paying any fees. (This advantage for mutual funds may be gradually lost as no commission ETFs become more available.)

The minimum purchase volume of an ETF is one unit. The need to pay a commission to buy that one unit, however, may be a problem.

No Commission ETFs

Then competition grew. Now one independent discount brokerage (Questrade) is advertising that all ETF purchases will be 0 commission. ETF sales, though, will cost their usual commission (which is usually about $4.95.) Two other independent discount brokerages (Qtrade and Virtual Brokers) and one discount brokerage (Scotia iTrade) are offering 0 commissions on the purchase and sale of select ETFs with the other ETFs costing regular commissions.

Commissions, in other words, may change frequently. It’s worth checking online to see what fees and commissions are being charged before deciding where to invest.

Mutual Fund Loads and Commissions

Mutual funds may also charge fees for purchases and sales.

No Load Mutual Funds

Many funds are called “no load” funds. Although you should always check carefully and thoroughly before buying, most of these “no load” funds do not charge a fee to purchase or sell the fund. Some, though, charge a fee if you sell units of the fund before a certain length of time has passed, anywhere from one day to 90 days. Read the details before buying.

Front End Load and DSC or Back End Load Mutual Funds

Unpleasantly, some mutual funds do still charge fees to purchase and sell units.
A fee charged to buy units in a fund is called a Front End Load. For example, it might cost $500 to buy $10,000 worth of units in a mutual fund.

A fee charged to sell units of a mutual fund is called a Back End Load or a Deferred Sales Charge or a Deferred Service Charge (DSC.) There may be a fee charged whenever units of a fund are sold. Or there may be a fee charged depending on how long that units have been held. For example, there may be a fee of 6.5% of the value of the units charged if a fund is sold within one year of purchase, that fee declines gradually to 0% if a fund is sold after being held for 7 or more years.

Read fund information carefully to see if loads or DSCs are charged before purchasing units. These fees can be very high.

Minimum Volume or Price Requirements to Purchase Mutual Funds

Although many mutual funds are “no load” that does not mean that an investor can buy just one unit of those funds. Many mutual funds have minimum initial purchase amounts. For some funds (like some PH&N funds) you may have to buy $5000 of a fund to get started. Many bank funds require a minimum initial investment of $500, although they may waive that if you set up an automatic contribution plan.

This high initial purchase volume and cost for some mutual funds may be a deterrent for some investors.

Mutual Fund Fees to Purchase and Sell Versus ETF Commissions

In general, ETF fees (commissions) to make purchases and sales are easier to see and understand. Because ETFs are sold throughout the trading day and because the commission is visible before an order is placed, it’s usually easier to know what costs you are paying.

You must be very careful before purchasing units in a mutual fund to be sure you understand all of the loads and fees charged by the fund.

Distributions from ETFs and Mutual Funds

Both ETFs and mutual funds may pay distributions (income) to investors. You can read the Fund Facts sheet to determine if an ETF or mutual fund pays any distributions and if it does, when it does.

There are also both ETFs and mutual funds that re-invest all earnings into the holdings of the fund. These types of funds do not pay any distributions (income.)

Re-investing Distributions from ETFs and Mutual Funds through DRIPs

A DRIP is a distribution re-investment plan.

Most mutual funds offer DRIPs. Instead of receiving cash distributions, the owner receives additional shares and fractional shares of the mutual fund. For instance, each month the BMO Mortgage and Short Term Income Fund pays me a distribution which is re-invested automatically into new units in the fund. (BMO InvestorLine has trouble accurately reporting the Net Capital Gain of this type of DRIPped fund. For details, please see Be Wary of the Unrealized Gain or Loss Column for Re-invested Mutual Funds with BMO InvestorLine.)

The full no-fee re-investment of distributions by mutual funds makes them an attractive investment for both dollar cost averaging and long term growth.

Many ETFs also offer DRIPs. However, in most cases the owner can only receive additional whole units of the fund. If part of the distribution is not enough to purchase another whole unit of the fund, that part is paid to the owner in cash.

The inability to earn partial units for an ETF DRIP is a drawback to owning an ETF instead of a mutual fund.

DRIP or no DRIP You Still Have to Pay Taxes

For taxable investment accounts, the owner still must declare and pay income taxes on the distributions even though they are re-invested. This applies to re-investment of both ETF and mutual fund distributions.

Distributions made within non-taxable accounts like RRSPs, TFSAs, RESPs, RRIFs and RDSPs are not taxed when they are made. They may be taxed, however, when the earnings are taken out of the plan. (Monies taken out of a TFSA are never taxed.)

The Fees Just Keep on Coming! Maintenance or Ongoing Fees for Mutual Funds and ETFs

Unlike when purchasing stocks, once you’ve bought an ETF you haven’t paid the last fee for it until you sell. Unfortunately, ETFs also charge an annual fee to unit holders. This fee covers costs for management of the fund, legal fees, the cost to buy and sell holdings within the fund, and other expenses. Mutual funds also have an annual fee made up of the same types of costs.

This maintenance fee is charged against the earnings the fund (mutual or ET) makes during the year. The fee is not charged directly to the unit owners. So if the holdings of the fund earn, say, 5% in capital gains, dividends and income, and if the maintenance fee for the fund is, say, 2%, then the people who invested in the fund will receive distributions worth (5-2)=3% of the fund for the year.

Unfortunately, funds do not always make a profit every year. If there are no earnings to pay the maintenance fee then some of the capital holdings of the fund will have to be sold to pay the expenses. The value of the fund (ET or mutual) will drop and the owners will have less valuable units.

The Management Expense Ratio, MER, for ETFs and Mutual Funds

This annual fee is usually described in the fund information as the MER or management expense ratio. It is usually expressed as an annual percentage of the fund’s value. This allows it to be compared easily to the annual percentage earnings of the fund.

Most reports about funds that say the fund earned, say, 7% last year mean the fund earned 7% AFTER subtracting the MER.

ETFs Have Lower MERs than Mutual Funds, Don’t They?

No.

There is no guarantee an ETF will have a lower MER than a mutual fund. Many do, but it is not required and not a given. You must carefully check the MERs for both mutual funds and ETFs before purchasing units.

There are some ETFs with very good, very low MERs. Vanguard offers several low MER ETFs. So do some iShares ETFs.

There are also some low MER mutual funds including some of the TD e-series mutual funds.

There are also some ETFs that have MERs that have crept up and into the same territory as the MERs charged by mutual funds.

Your best plan is to pick what kind of holdings you want in your fund first. For example, you might want a fund that holds the same assets as the S&P 500 Index. Then look at the mutual funds and ETFs that offer a mirror of this index and see which ones have the lowest MERs and the lowest trading costs (commissions and loads.)

How large your original purchase can be and how often you want to add new contributions to your holdings may also be a factor in choosing between an ETF and a mutual fund.

Taxes and ETFs Versus Mutual Funds

If you hold all of your ETFs and Mutual Funds inside tax-sheltered accounts this information won’t be very important to you.

However, if you are investing in the “real world” and not inside an RESP, RRSP, RRIF, RDSP, or TFSA, this information may be of interest.

Each time a fund, mutual or ET, sells a holding it will make a capital gain or a capital loss (unless it happened to sell it for exactly what it initially acquired it for). Just like for personal taxes, the fund management keeps track of these losses and gains for the year and adds them up. Overall, the fund may make a capital gain or loss for the year.

This gain or loss is reported to owners of the units at the year end. The owners must then report the gain or loss on their income tax filing. If there was a net gain, the owner must pay tax on it unless he or she has other losses that can be applied against it.

Both Mutual Funds and ETFs Report Year-End Capital Gains or Losses

The method of selling units of a mutual fund and of an ETF can affect the size of the annual capital gain or loss.

When investors sell units in a mutual fund, the fund tries to pay them with monies generated by new investors buying units in the fund. Sometimes, however, everyone is selling their mutual fund units at the same time and no one is buying them. In those times, the fund must actually sell holdings to pay the monies to the investors redeeming their units. Later on, when the new investors start buying units again, the fund will have to buy new holdings for the fund.

Before investors can sell units of an ETF they must find a buyer. The investor places a trading order offering to sell his or her units. Another investor must place a trading order offering to buy those units. This means most of the time ETF units are sold and purchased in lock step. Very rarely will an ETF have to sell assets to generate cash to pay an investor who is selling off their units. This means that the ETF will generate fewer capital gains and losses due to sales (redemptions) of units than a similar mutual fund.

(This is a very simplistic explanation. The actual steps used by both ETF and mutual fund managers to minimize trading holdings are very complex.)

The fact is that an ETF is likely to have a lower capital gain or loss to report at the end of the year than a similar mutual fund. That would result in owners of the ETF having to report a lower capital gain or loss on their income tax filing.

Conclusion: Pros and Cons of ETFs and Mutual Funds

Mutual Fund Pros

  • Many charge no fee (load) to purchase or sell units.
  • Many allow a DRIP and the DRIP permits holders to earn fractional units.

Mutual Fund Cons

  • Front end load and back end or DSC load mutual fund fees make some funds more expensive and less flexible to sell.
  • Requirements to hold many mutual funds for certain lengths of time (often 90 days) to avoid an early redemption penalty reduce flexibility.
  • Not knowing the price before making a purchase or sale makes the investor feel less certain. An investor may hesitate while trying to decide whether the price will be acceptable or not.
  • There may be minimum initial purchase size requirements.
  • Mutual funds are prone to having to report a higher capital gain or loss each year than a similar ETF. This affects investors who hold the mutual fund in a taxable account.

ETF Pros

  • Some ETFs are now zero commission to buy or sell.
  • Being able to set a fixed price for purchases and sales gives the investor more control.
  • Being able to see the price before purchasing or selling gives the investor more confidence.
  • There are usually no minimum holding periods required for ETF units.
  • There is usually no minimum initial purchase size requirement.
  • ETFs are prone to having a lower capital gain or loss to report each year than a similar mutual fund.  This can reduce the tax for an investor holding the ETF in a taxable account.

ETF Cons

  • Unless a no commission ETF can be found, the trading commission makes regular contributions of small amounts costly.
  • Most ETFs allow DRIPs but do not allow owners to earn fractional units.

Conclusion

So ETFs are neither better nor worse than mutual funds. Both offer different characteristics. An investor will have to choose the best combination of features for the lowest price.

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Do you invest in ETFs or mutual funds? Why did you choose which type of fund, ET or mutual, to purchase? Please share your experiences with a comment.

The Benefits and Drawbacks of Mutual Funds

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High management fees, unexpected costs to sell funds, and high pressure sales tactics have made many investors wary of purchasing mutual funds. But like any investment type, there are pros and cons to adding funds to your portfolio. Mutual funds don’t just let you buy a piece of the equity market. You can use them to hold a variety of assets. There is merit in examining the benefits of mutual funds and in deciding how to evaluate which funds you might want to get.

Benefits of Investing Using Mutual Funds

Ability to Hold Expensive or Awkward Assets

Mutual funds may give you a chance to invest in an asset you couldn’t afford to otherwise purchase. For example, a share (yes one) in Berkshire Hathaway costs $151, 579 $168 900 US today [in February 2014]. In fact, it’s up $1079 2000 US in 2 days so far today, so you may want to hurry and get yours before the price runs away from you. A share of Apple is a much more affordable $449 529. Why not go buy a few board lots?

There are mutual funds that hold both Apple and Berkshire Hathaway. (One available only to Americans is Matthew25, MXXVX.) Most of these funds cost about $25-100 per unit. That makes buying a share of the value of expensive assets achievable even for investors without million dollar cash balances.

Mutual funds also can let you invest in awkward assets like precious metals. Owning physical gold, silver and platinum requires having a safe storage spot. It may also be difficult to re-sell your holdings quickly if you change your plans. Buying precious metals through a mutual fund like the BMG Bullion fund (BMG 100) that holds real physical metals for you in secure storage might be preferable.

Expert Knowledge

I know that it sounds hokey but it is true that most of the better mutual funds have a very knowledgeable manager in charge of the money. If you have zero interest in learning about business and finance there is value in paying someone else to provide you with that service.

Two caveats:

  1. True index funds do not rely on any expert knowledge. They just mimic an index. Don’t pay for expert advice if you’re not getting any! A true index fund should have a very low MER (fee.)
  2. Most ETFs are managed by experts who are just as knowledgeable as mutual fund experts. The fee you pay for their expertise, however, may be lower. Check the fees and MERs to compare similar ETFs and funds.

Low Entry Price and Low Minimum Purchases

Many mutual funds are inexpensive on a per unit basis. That allows investors to get started while they are still building up their savings. Many banks, for example, only require $500 to start investing in a mutual fund. The ING Direct Streetwise funds have no minimum investment. If you had $10.13 $11.61 you could buy one unit of their Streetwise Balanced Growth Portfolio right now.

Often No Fee to Purchase or Sell

To buy or sell equities and most ETFs you have to pay a fee called a trading commission. Many mutual funds can be bought and sold without paying any trading commission. This includes funds purchased directly from the issuer, like a bank, and funds purchased through an online brokerage.

Be aware, though, that some funds charge a fee if they are sold within a certain time after they were purchased. For example, many mutual funds charge a fee if sold within 90 days of the purchase.

Active management, If Desired

If you like the idea of having a person actively managing your investment, there are many mutual funds that are actively guided by a manager. For example, that manager may be making daily or monthly decisions about whether to purchase or sell specific equities held by the fund. In theory, a good manager may spot valuable assets trading at a discount and buy them to gain that extra value.

Index coverage, if Desired

If you prefer a Couch Potato investing strategy, there are mutual funds that do not have any active management. Instead, the fund buys and holds the same investments as the index after which it is modelled. This type of fund should charge less for management fees.

Dollar Cost Averaging

This is one of those theories that sounds good but doesn’t always seem to make much difference in the real world. Anyway, the theory is that if you buy a certain fixed amount of an investment at intervals, over time you will buy some when the price is high and some when the price is low. That should result in better earnings than if you accidentally bought it all when the price was high. (It will actually result in less profit than buying it all when the price is low.) So for example, if you buy $50 worth of a mutual fund every month you are less likely to buy all your units when the price is high.

This was a concept dating back to The Wealthy Barber. I don’t know if it’s still being quoted much or not!

One real advantage of dollar cost averaging is that it stops analysis paralysis. Instead of dithering and never investing for fear of buying high, the investor goes ahead and buys.

Diversification

Obviously if you spend $50 to buy one share of one company you are not going to have as diversified an investment account as if you spend $50 to buy a small share of 100 companies held by a mutual fund. If you believe that diversification is important for equity investing, mutual funds can make it easy.

Diversity can also refer to types of assets. You can diversify your portfolio by buying units in a bond fund, an equity fund, and a gold bullion fund. This will give you several types of assets even if you have a small total dollar value portfolio.

Tool to Purchase Bonds Efficiently

A bond fund manager will invests in a selection of bonds. They may be government-issued bonds, corporate bonds, or municipal bonds. They may have terms to maturity of 1-50 years. The fund manager can negotiate lower fees for volume purchases. The PH&N Total Return Bond Fund https://www.phn.com/Default.aspx?tabid=887 is an example of a bond fund.

Buying units in a bond fund requires less capital investment for more diversification with lower purchase commissions and active management. What’s not to like?

Drawbacks of Investing Using Mutual Funds

Front End and Back End Loads

Some bond funds charge a fee to purchase the fund. It is sometimes called a Front End load. If, for example, you have $1000 to invest in a fund, they may take a $100 fee for purchasing the load. That is a 10% load. You may not notice the fee, though. If they just tell you that $1000 will buy you 47.98 units, do you really know you should have got more units if there was no fee? Always check whether there is any fee, charge or commission for buying a fund.

You can probably guess a Back End Load is charged when you sell a mutual fund. Often this load decreases the longer you hold a fund. It may even reduce to zero after several years. Why do the fund issuers set up these kind of declining loads? It allows them to say the back end load is to reduce the number of people jumping in and out of the fund. I suppose it does. But they don’t say it also deters people from selling even when they know they should. People hate to pay a fee especially to sell a fund that has already lost them money. Try to avoid all Back End Loads, even declining ones.

These fees can also be called Deferred Service Charges or Declining Service Charges.
In most cases, the funds you want are called “no load” funds. Only if a mutual fund offers amazing benefits should you consider paying a load.

Management Expense Ratios (MERs) May be High

Most of the fees you pay to own a mutual fund are bundled up in something called the MER. The MER usually includes any payment made to the fund manager and staff, any commissions charged to the fund when it bought and sold investments, legal fees, accounting fees and any payments made to the bank or financial advisor who sold the fund to you. That’s right: for many funds you pay a fee each year to the person who sold it to you. It’s called a trailer fee. Why did you think they were so eager to sell you a mutual fund and not a GIC?

The MER is expressed as a ratio, or commonly as a percentage of the fund per year. For example, many Canadian funds charge a MER of 2% per year. That means that 2% of the fund’s value is paid to cover expenses each year. In theory, the fund should also have income. The 2% cost is deducted from the income. The difference is what is reported as the fund’s return for the year. So if the fund earned 10% income and had a 2% MER you’d see the fund reporting an 8% annual return for the year.

What happens, though, if the fund does not have any income for the year? Then the 2% MER comes out of the capital invested in the fund. So a MER can actually make a fund suffer a loss! And if a fund is having a really bad year and has already lost 15% of its value due to, say, a stock market crash, then the MER will exacerbate the problem. In that case, if the MER is 2%, the annual return for that fund will be -17%.

That’s right, in a year when your mutual fund has lost money, the advisor who sold you the fund still gets paid, and the fund manager still gets paid, but you don’t.

ETFs also charge MERs but they are often lower than mutual fund MERs. You have to watch this closely though as it’s not always true. And some funds, like some of the TD Waterhouse e-funds have very low MERs.

Minimum Holding Periods

Many mutual funds require you to stay invested for a minimum period of time, often 90 days. If you sell before then, you will be charged a fee. The fee can be quite high. Be sure to check for minimum holding periods before purchasing a fund.

High Initial Investment

Many well-respected funds have a high initial investment requirement. They can demand $5000 or more per fund or per fund issuer to start.

High Pressure Sales Tactics

Unfortunately, the buying process can be made very uncomfortable due to financial institutions using high pressure sales tactics. You may go in just wanting to invest in a GIC and end up buying a mutual fund instead. Try to have a plan before visiting a bank branch or financial advisor’s office. Take a friend or relative for moral support who can insist you leave the meeting if you seem harassed.

Over Diversification

No one needs a dozen mutual funds. If you think equity diversification is very important to you buy a fund that covers the entire TSX, a fund the covers the entire US NYSE, and a fund that has lots of holdings outside of Canada and the US. To diversify your types of investments, add a bond fund and a gold fund and you’re done. That’s 5 funds.

You can simplify even further by buying a good balanced fund that holds equities, bonds and precious metals.

Readers may remember me mentioning once before about a mutual fund plan that we purchased while under the influence of high pressure tactics many years ago. It held not one, not two, but 4 bond funds, 2 money market funds, and 4 equity funds. It was absolutely ridiculous but this was the “standard” package being recommended to low-risk-tolerance investors by one of the Big 5 banks. Buyer beware!

Conclusions
The benefits of buying mutual funds include allowing efficient investment in bonds and bullion. For a low initial investment a buyer can build a portfolio of no load low MER funds that offer index mimicking or active management of equity investments. Unlike most ETFs, there is usually no fee to purchase or sell mutual funds. Many mutual funds also allow complete reinvestment of dividends and income in additional units, including fractional units.

Many of these benefits are also offered by investing in ETFs.

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Have you discovered other pros and cons of mutual funds? Please share your experiences with a comment.2