Investing in a broad mix of financial products is critical for investors to diversify and reduce their investment risk, and one reason that Canadians invest their money in funds.

Judging from traffic to the IEF’s website, www.getsmarteraboutmoney.ca, many people want to know more about equity mutual funds and exchange-traded funds (ETFs) for the equity portions of their portfolios. This article is a primer on some of the differences between them.

How does an equity mutual fund differ from an ETF?

A typical equity mutual fund invests in a group of stocks or other investments picked by a professional investor. These funds give you a broader range of investments than you would likely buy on your own, and the stocks are picked by professionals with research resources at their disposal.

ETFs and index funds have recently become popular new investing options for Canadians. They’re a bit like a stock and a bit like a mutual fund. Like a stock, you buy ETFs on a stock exchange through a broker or discount brokerage account. Like a mutual fund, ETFs let you invest in a group of stocks or other investments.

The most important differences between equity mutual funds and ETFs are the investment style with which they are managed, and their costs.

Highlighting some of the differences between Exchange-Traded Funds (ETFs) and mutual funds.

In general, equity mutual fund managers try to pick a mix of stocks that will outperform other stocks in the same segment of the market. For example, a fund can focus on a segment such as technology or large Canadian Companies. In essence, the fund manager is ‘actively’ managing your money to try to achieve higher returns for you—for a fee. In order to outperform its index, it has to deliver a return that exceeds the cost of the fund.

ETFs match the performance of the market by following the accepted benchmark for the category of investments that they track. They do this by buying investments that mimic the makeup of the market—in other words, they ‘passively’ hold the same stocks does as a selected market index. After fees, they will always trail the market return slightly.

While differences between these two investment products are starting to blur as mutual fund companies begin to offer ETF-like products and some ETFs start taking on the characteristics of mutual funds, in general, they still hold true.

Impact of Fees

It is vital that Canadians pay attention to fees when they invest. Every dollar spent on fees is a dollar that cannot be reinvested, so you also lose the compounding effect it would have had in the future.

Lower costs mean that you may pay less to own an ETF than a typical mutual fund. Since the ETF tracks an index, the fund manager doesn’t have to research each investment. They generally pay lower sales fees to the investment sales force as well, which is reflected in lower ongoing costs. Mutual funds pay higher fees to their sales force, and include commissions and other costs embedded in the Management Expense Ratio (MER). These MERs can have a significant impact on your total return.

There is plenty of research that shows fees are linked to the long-term returns. As Paul Justice, ETF Strategist with Morningstar, has said: “At Morningstar, we’ve done countless studies on the best predictors of future fund returns, and the best indicator, hands down, is fees—the lower, the better.” After all, a fund with high fees must perform better to make up for its increased expenses. If it doesn’t, this added burden results in lower returns for the investor.

That said, while a fund’s fees are important, there are higher-fee products with returns that exceeded the market over time. For example, from 2006-09, about 25 per cent of actively managed Canadian equity funds outperformed the S&P/TSX Composite Index. If you look at another period (2004-09), just under 10 per cent of these funds outperformed the index. The point is some funds outperform markets some of the time. This is in contrast to ETFs, which will consistently underperform their market index by the amount charged in fees.

Take the time to understand your options and how they match your investing needs. Numerous investing sites provide good analysis of ETFs and mutual funds including www.getsmarteraboutmoney.ca, your provincial securities regulator and many well-informed sources in the media and consumer groups.

“Investing in a broad mix of financial products is critical for investors to diversify and reduce their investment risk, and one reason that Canadians invest their money in funds.”