There are several different financial products available for investing in the stock market and bond market.
The two most popular products are exchange traded funds and mutual funds.
- What’s the difference between an exchange traded fund and a mutual fund?
- What are the costs and benefits associated with each product?
- Upon comparing the two financial products, which one offers the most advantages?
Let’s answer these questions by reviewing both products.
Exchange Traded Funds vs Mutual Funds
An exchange traded fund is better known as an ETF. An ETF is a marketable security that tracks the movement of various asset classes like
- stocks
- bonds
- commodities
- foreign currencies
- baskets of assets like an index fund.
An investor in an ETF receives shares, similar to shares received by the owner of a stock. The ETF trades like a common stock on a stock exchange.
The price of the ETF moves up and down on a daily basis as the ETF shares are bought & sold.
Brief History Of ETFs
The first ETF was introduced in January 1993 and was an ETF designed to track the performance of the S&P 500 stock index. The official name of the product was S&P 500 SPDR.
This ETF is still in existence today and is a very popular ETF within the investment community. These days, the product is colloquially known as “spiders.”
As of May 2017, investors held over $4 trillion in ETF products on a global basis. There are nearly 7,000 different ETFs available for individual and institutional investors.
A mutual fund is an investment vehicle consisting of a pool of funds collected from individual investors for the purpose of investing in various securities such as stocks, bonds, money markets and other similar assets.
Each mutual fund is professionally managed by a money manager. The manager’s responsibility is to invest the mutual fund’s capital in an effort to create capital gains and income for the fund’s investors.
An investor in a mutual fund receives shares, similar to shares received by the owner of a stock. Unlike a common stock, the vast majority of mutual fund shares do not trade on a stock exchange.
Shares are purchased & redeemed at the fund’s net asset value (NAV) per share.NAV is simply the total value of the securities in the portfolio divided by the total number of shares outstanding.
History Of Mutual Funds
The first mutual fund was introduced in 1924 however individual investors didn’t begin to invest on a large scale basis until the 1950s.
The mutual fund industry experienced a large increase in participation in conjunction with the roaring bull market of the 1980s beginning in 1982.
As of May 2017, investors held over $36 trillion in mutual fund products on a global basis.
There are over 110K regulated mutual funds available for individual and institutional investors.
Costs and Benefits
ETFs are particularly popular among individual investors because of the low cost structure. The average equity ETF carries an annual fee of 0.40%.
However, the vast majority of ETF dollars are invested in index funds. These particular ETFs charge an average annual fee of only 0.23%.
The “big three” firms in the equity index ETF space are Vanguard, State Street & BlackRock.
These three firms service nearly 70% of all ETF assets. By virtue of their size within the ETF industry, the firms have the ability (through economies of scale) to charge significantly lower fees in comparison to other companies.
The “big three” annual fees are well below the industry average.
- Vanguard’s index ETF fund carries an annual fee of 0.04%.
- BlackRock has a similar fund with a 0.04% annual fee.
Fixed income ETFs are also popular among investors. During the past few years, the average annual fee for a fixed income ETF has declined from 0.26% to 0.20%.
Decline Of Mutual Fund Fees
Mutual fund fees have also declined during the past number of years but have been unable to match the fee reductions within the ETF community.
In comparison to ETF fees, the mutual fund industry finds itself in second place. All fees within the ETF industry have declined over the years and it’s likely this trend will continue.
The average annual fee for a typical stock index mutual fund is 0.63%. Twenty years ago, stock index mutual fund fees were 1.04%. The industry has reduced its fees within the past two decades but the mutual fund industry still trails the ETF industry.
The results are about the same in the fixed income arena.
Bond funds within the mutual fund industry have an average annual fee of 0.56%. Similar to stock mutual funds, the bond fund fees have fallen over the course of the past two decades still not keeping pace with ETF fee reductions.
Why Are ETF Fees Lower?
Mutual funds are managed by professional managers and there is a rather steep price tag attached to the management of each fund.
The main “selling point” within the mutual fund industry is that mutual funds provide individual investors with a professionally managed account.
This is true but historical performance results would suggest that the added expense of a managed account does not adequately compensate the investor in terms of increased rate of return.
Professionally managed mutual funds are not worth the added expense.
The amount paid in fees and the low performance is one of the main reasons Mark Soberman fired his “money manager” and finally saw growth in his retirement account.
The way in which ETFs and mutual funds relate to their investors also explains why there is such a wide gap in the fee structure within both industries.
When a mutual fund company receives a buy or sell order from a customer, it must process the order internally.This requires a fair amount of record keeping, documentation & compliance issues.
Once the customer’s order has been processed, the mutual fund’s professional manager must invest the funds in the marketplace. This involves buying or selling securities along with paying all the necessary spreads & commissions.
This process costs money and all fees and expenses are passed through to the mutual fund investor.
A typical ETF transaction involves less complication because (for most investors) ETF trades take place with other investors and not with the mutual fund company itself. As a result, ETF customers enjoy lower fees.
These are just a few of the reasons why the average annual fee for an ETF is significantly lower than its mutual fund counterpart.
As an added bonus, ETF investments tend to be more tax efficient versus investments in mutual funds.
Which Offers The Most Advantages?
Based on a side-by-side comparison, it’s more advantageous to invest in an ETF versus a mutual fund.
Over the long run, the lower fee structure of the ETF far outweighs the benefit of a professionally managed account with a mutual fund.
Let’s compare a hypothetical account:
ETF Investment vs Mutual Fund Investment
Initial ETF Investment $10K
Average Annual Fee (%) .23%
Average Annual Fee ($) $23.00
Annual Rate of Return 7%
Account Value After 10 years $19,335.41
Initial Mutual Fund Investment $10K
Average Annual Fee (%) .63%
Average Annual Fee ($) $63.00
Annual Rate of Return 7%
Account Value After 10 years $18,769.28
It’s less expensive to invest in an ETF versus a mutual fund.
In this particular scenario, $10K is invested for 10 years (assuming a 7% annual rate of return).
The ETF investment easily outperformed the mutual fund investment due to lower fees.
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References
Morningstar, Inc (www.morningstar.com)
Value Line (www.valueline.com)
Statista (www.statista.com)
Investment Company Institute (www.ici.org)
2 Comments
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I was impressed reading about the ETF strategy. I did hear about ETF, but didn’t know that they were far superior to Mutual Funds. i will gather some money and will start investing into ETF. My Mutual Funds were giving me only 3%-4% gain, and sometimes in the negative range.
Don’t forget, an ETF isn’t there to way outperform a mutual fund. You are usually best in mutual funds to invest in low cost funds – and usually passive index funds tend to be the most consistent over time. There are exceptions in actively managed funds but they tend to be timed more which can be a challenge. What you get with an ETF is usually very low costs, and the ability to easily enter and exit.