On the surface, mutual funds and exchange-traded funds (ETFs) look alike. They both pool investments, like stocks or bonds, charge fees and offer reports, such as financial statements, quarterly, semi-annual or annual statements, but that’s generally where the similarities end.
Here are four important differences between mutual funds and ETFs:
1. Active vs. Passive
One of the main differences between mutual funds and ETFs boils down to how investment decisions are made. Most mutual funds are typically managed by a portfolio manager who takes a hands-on approach to decide which investments the fund holds and typically follow a set of rules around the types of investments they buy and sell to achieve their investment objectives. This means they have the freedom to respond to changes in the market in an attempt to limit losses and pursue opportunities that could allow them to outperform their benchmark.
Mutual funds and ETFs have similar fees and expenses, but there is often a disparity between how much the fees and expenses differ. Typically, the management expense ratio (consisting of the management fee and other operating expenses) of ETFs tend to be lower than mutual funds. The average Canadian equity mutual fund MER is about 2%, but it’s not uncommon for them to climb above 3%.
By comparison, the typical MER for equity-focused ETFs is about 0.54% and, apart from a few exceptions, they are almost all below 1%. While the difference between the MERs for a mutual fund and ETF may seem small, it can add up over time. Consider the impact on a $1,000 annual investment earning 5% over 15 years. A 2% MER for a mutual fund costs you $3,501 in fees over that time, whereas an MER of 0.54% would cost just $1,011. After factoring in returns, it would mean the difference between owning an investment worth $19,157 or $21,646 (See Fee Calculator)
3. Buying and selling
Apart from cost, how you buy and sell ETFs and mutual funds is another notable difference. ETFs trade like stocks on a stock exchange, which means every fund can be traded during the hours the exchange is open for trading. Each ETF has a ticker and the market price on the exchange can fluctuate during a trading day.
Like a stock, each ETF will have a “bid price” and an “ask price” on the exchange. A bid price is the highest a buyer is willing to pay for a security, whereas the ask price refers to the lowest amount a seller will accept for a security. The difference between the two is called the “bid-ask spread” and it is a trading cost for investors. Finally, while the market price of an ETF is generally expected to track the underlying value of the portfolio held by the ETF, the ETF may trade above the underlying value (commonly referred to as trading at a “premium”) or below the underlying value (often referred to as trading at a “discount”).
4. Automatic contributions
Setting up an automatic contribution plan can be an effective way to grow your savings quickly. Investing smaller amounts at regular intervals is more manageable than investing in one lump sum. A mutual fund account can regularly steer those new contributions into the mutual fund if you set up an automatic contribution plan to help you achieve your investment goals.
That’s not always the case for ETFs. Many discount brokerage accounts don’t allow automatic ETF purchases, although some robo-advisors are now providing this service. If your account doesn’t permit automated purchases, it will be up to you to remember to invest the funds periodically. Another downside of this approach is that you may also incur trading costs each time you do. While trading fees may be low, they can quickly add up when investing small amounts.