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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