A few weeks ago, a client asked me to explain the differences between mutual funds, index funds, and exchange-traded funds or ETFs. So I took a deep breath and gave it my best shot. My goal was to explain—in the most succinct manner —the key features, costs, risks, and differences that he’d need to understand as an investor.
A Short History
While some trace the first-ever mutual fund back to 1774, the modern mutual fund began in 1924. Interestingly, both 1774 and 1924 were the result of tough economic times.
Let’s start with the modern mutual fund, which was a formidable innovation with both positives and negatives.
The Positives Of Mutual Funds
First, let’s talk about the positives of mutual funds.
Mutual funds were promoted as vehicles of diversification that would increase the appeal of investments to smaller investors with minimal capital, back when most Americans believed stocks were too risky and solely for rich people.
These funds gave small investors the opportunity to pool resources and buy a basket of diversified securities, when the average small investor could not, on his own, afford to purchase enough stocks to build a diversified portfolio.
The modern mutual fund also broke the rich-poor barrier. Back in 1924, professional money management was only available to the rich, but mutual funds brought professional investment advice to the masses, at an affordable fee that was a small percentage of the amount they invested.
Another positive innovation was the introduction of the open-end mutual fund, a really important milestone in mutual fund evolution. This new structure allowed investors to make withdrawals on demand, so one could tap into her assets and redeem shares at their true net worth at the end of each trading day.
Today, open-ended mutual funds hold the vast majority of the $3.6 trillion dollars invested and are the primary form of market participation for small investors. They offer a wide array of investment options for diversification and portfolio allocation between stocks, bonds, foreign equities, and what are called “alternative investments”.
The Negatives Of Mutual Funds
Now to the negatives.
In spite of their positive attributes, mutual funds have a few drawbacks that you should be aware of, so you can account for them in your investment strategy.
Realized Capital Gains
The first drawback relates to taxes. If the mutual fund manager sells some of the fund’s investments during the year, any realized capital gains must be paid to shareholders. While this seems reasonable, it can cause a regrettable situation where shareholders receive distributions and have to pay capital gains taxes, even if their account value is lower at the end of the year. Take it from someone who experienced this long ago. It is no fun to pay taxes when the value of your account has dropped.
I do have one strong warning for the fund investor. If you’re not careful, buying a fund near the end of the year may require you to pay taxes on other people’s gains. This happens if you buy close to the distribution date. The distribution will be made to you as a shareholder, but you would not have been in the fund long enough to earn those gains. Paying taxes on someone else’s gains is an awful thing. So be careful!
Active Mutual Fund Management May Charge Higher Fees
Here’s something else to consider. In the U.S., more than half of all mutual funds are actively managed. However, active management strategies require more research, pay more in fees to brokers, and charge extra fees to pay the managers. These extra fees could cause the fund to underperform relative to the market and may bite into your returns.
End Of Day Pricing
Unlike stocks, mutual funds lack intra-day price transparency. This means that the price of a mutual fund unit is recalculated at the end of each trading day and orders to buy and sell the fund are based on the end-of-day unit price. So if an investor buys units at 10:30 am, he will not know the price paid per unit until after close of trading on that day. This may work for or against the investor.
Here’s an example of how this could go against you. If you sold 100 units of a fund in the morning when the market was down “only” 30 points, you will receive the price as of the close of trading that day. If the market swings lower and closes down 500 points, your sale would reflect that substantially lower price. Ouch!
Let’s move on to Index funds. John Bogle, the venerable founder of The Vanguard Group, started the First Index Investment Trust in December 1975. His idea was to create a low-cost vehicle which would invest in a basket of stocks representing the entire market. Instead of beating the index and charging high costs, his index fund would mimic the index and attempt to match its performance—thus achieving near market returns, with significantly lower costs and fees.
When it was introduced, Bogle’s concept was considered un-American (if you can believe it!) and was widely ridiculed. It was called Bogle’s Folly. Needless to say, indexing got off to a very slow start and only gradually picked up steam as institutional investors started to see its potential benefits. Thereafter, small investors also started to embrace the idea, and before long, the Vanguard S&P 500 fund grew from $11 million to over $400 billion (as of March 2018).
If you’re interested in learning more about the early days of the Index Fund, written by John Bogle himself, I’ve included a link here.
Index Fund Positives
Index funds have a lot of positives, but I’ll cut to the one that really matters. Index funds offer a low-cost and minimal-trading strategy that can arguably outperform many actively managed mutual funds.
Moreover, innovation has resulted in the indexation of a large variety of markets and industries, giving investors a wide range of fund choices.
Index Fund Negatives
On the downside, index funds are still mutual funds and contain some of the same drawbacks. For instance, index funds too are required to distribute taxable annual gains by year-end. On the plus side though, index funds generally have small distributions, if any, because of their buy-and-hold investing style.
And like mutual funds, index fund purchases and sales are settled at the end of each trading day, exposing you to the possibility of buying in at the top or selling at the bottom of each day’s value.
ETFs: A True Modern Innovation
Finally, let’s talk about Exchange Traded Funds or ETFs.
The first ETF was created in 1989, in an attempt to correct some of the drawbacks of mutual funds. Unfortunately, a Federal Court deemed this early ETF to be more akin to a futures contract than to a security, so it was quietly quashed. But the basic idea of an ETF was too powerful to ignore.
It took another four years, until January 1993, for the very first ETF to get listed in the U.S. This was the infamous S&P 500 Spider (SPDR) which was designed to replicate the price and yield performance of the S&P 500 Index.
ETFs gained in popularity because they offered structural innovations that corrected some of the deficiencies of mutual funds.
ETFs are not required to pay distributions from capital gains at the end of each year. Instead, the ETF holder only incurs a capital gain or loss on selling the ETF. So this gives investors control over when to take capital gains and losses.
Unlike mutual funds and their end-of-day settlement drawback, ETF shares are traded continuously through the trading day, so you know exactly what price you are getting at the moment of sale.
Like stocks, ETF investors, can borrow against the value of their shares and trade on margin if they wish to and be shorted, if a speculator wants to bet against the market.
Now to the negatives of ETFs.
Wall Street has witnessed an explosion in the number and types of ETFs available to investors. Some ETFs go up when the market goes down and some go down when the market goes up. And some go up or down 2 or 3 times as much on a given day.
Also, ETFs will fluctuate with changes in market conditions and are not suitable for all investors. Since ETFs trade like stocks, they are subject to brokerage fees and trading spreads. Therefore, ETFs are not effective for dollar cost averaging small amounts over time. ETFs do not necessarily trade at the net asset values of their underlying holdings, meaning an ETF could potentially trade above or below the value of the underlying portfolio
So while some ETFs can be very risky and charge higher than average fees, there is a universe of over 2,000 ETFs that track every sector, region, and asset class and build a well-diversified portfolio.
So, to wrap up, a mutual fund’s founding idea of pooling your assets with others is a tremendous opportunity to investors and our economy.
And the argument on active versus passive strategies will continue for some time, with some worrying that a market controlled by passive investors may not be able to identify or reward good companies, while others may believe the market will find a way.
If simplicity and low fees and expenses are important to you, then you may find index funds to be more appealing. ETFs have the same but can be a lot riskier if you’re not careful.
I know this profusion of choice—between mutual funds, index funds, and ETFs—can be confusing, so before you randomly select something, do a fair amount of research. Or, better yet, consider having an advisor help you pick a combination that’s right for you.
Investing involves risk and investors should carefully consider their own investment objectives and never rely on any single chart, graph, or marketing piece to make decisions. The information contained herein is intended for information only, is not a recommendation to buy or sell any securities, and should not be considered investment advice. Please contact your financial advisor with questions about your specific needs and circumstances. There are no investment strategies, including diversification, that guarantee a profit or protect against loss. Past performance doesn’t guarantee future results. Equity investing involves market risk, including possible loss of principal. All data quoted in this piece is for informational purposes only, and author does not warrant the accuracy, completeness, timeliness, or any other characteristic of the data. All data are driven from publicly available information and has not been independently verified by the author.
Equity investing involves market risk, including possible loss of principal. Mutual funds are sold by prospectus. Investors should read the prospectus carefully and consider the investment objectives, risks, charges, and expenses of each fund carefully before investing. The prospectus contains this and other information about the investment company. The return and principal value of mutual fund shares fluctuate with changes in market conditions. When redeemed, shares may be worth more or less than their original cost.Investments seeking to achieve higher rates of return generally involve a higher degree of risk of principal.
Investment securities have risk and may fluctuate with changes in market conditions. Consideration should be given to the possible loss of a part or all of principal invested.