Sound investment management always starts with asset allocation. The biggest decision you can ever make as an investor is the portion of your assets you invest in stocks. This decision alone is responsible for around 90% of the returns you’ll see over the years in your portfolio. The other 10% is based on whether you’re investing in U.S. stocks or international stocks, large cap or small cap, and value or growth.
Once you decide the proper allocation for you and your family, the next step is to select specific investments to buy. Maybe that’s an S&P 500 index fund. Perhaps it’s a small cap value stock fund. Whatever the asset class, if you choose to invest in a fund you’ll have two predominant choices: a mutual fund or an exchange traded fund (ETF).
Both can be great investment vehicles, but they are very different animals. Making a sound decision surrounding which vehicle is best for your strategy is important, and one that many investors overlook.
This post will describe these differences, and how to determine which investment vehicle is right for you.
Mutual funds have a pretty basic structure. You give money to a mutual fund manager. They give you back shares of their fund. Pretty simple. The fund manager then takes your cash and uses it the next day to purchase more securities for the portfolio.
The value of the fund is determined at the end of every trading day. Mutual fund managers are compelled to determine the “net asset value” of their fund, based on closing prices of each security held in the fund. The math here is pretty simple. If the fund holds 50 stocks, the manager adds up the portfolio’s total value based on shares held of each of the 50 companies using end of day market pricing. Divide the portfolio’s total value by the number of outstanding shares of the fund, and voila! You have your net asset value per share.
This type of structure is beneficial to investors. By investing in a mutual fund you’re assured to have accurate, daily pricing of what your fund holdings are worth. It takes away liquidity risk too, as mutual fund managers are required to redeem shares at the fund’s NAV whenever investors want. (Although they can impose some restrictions & charge penalties for doing so, in some circumstances).
Exchange traded funds are a relatively new animal, and have only been around for about 25 years. They’ve grown immensely popular, and currently have over $1 trillion in assets managed through them.
There are a couple primary parties involved in an exchange traded fund. The first is the fund’s sponsor, or manager. The sponsor is the group who decides what securities will go into the fund, what the cost structure will be, and other details about how the fund is to be managed. ETF sponsors are typically large banks and asset managers.
Equally important to the structure of ETFs are authorized participants. While a sponsor is the party who creates the structure and details of an ETF, they’re not the one who actually creates shares. This is done by a group of authorized participants, which are typically trading desks of various wall street investment banks.
Authorized participants have the power to create and destroy shares of ETFs they’re licensed to trade in. For example, State Street is the bank sponsoring SPY – the biggest ETF, and one that tracks the S&P 500. To create shares of the fund that you and I can purchase on the open market, State Street (as the fund’s sponsor) distributes the list of companies to be included in the fund to each of their licensed authorized participants. Being an S&P 500 index fund, this list is simply the S&P 500, and is updated each quarter whenever the index reconstitutes.
The authorized participants use that list to create shares of the fund. Using their own cash, the group buys each individual company on the list and places them in a trust. They are then free to create a proportionate number of shares of the ETF, selling them on the open market. Anyone buying the newly created SPY shares has a legal claim to the underlying companies sitting in the trust.
As the name implies, ETFs are bought and sold over an exchange, just like a stock. This is helpful for investors, since you have real time pricing on the fund you’re transacting in. (Compared to mutual funds, where your pricing depends on the net asset value at the end of the trading day).
It also brings some risk, since the market price can deviate from a fund’s net asset value. Since ETFs trade over the exchange, their price is determined purely by supply and demand – just like any company’s equity shares. It’s not directly tied to the value of the companies in the portfolio.
This is where the authorized participants come in. Remember that an authorized participant is free to create and destroy shares by purchasing and selling the fund’s underlying holdings. If the price of an ETF on the open market trades far enough away from that fund’s net asset value, the authorized participant is incentivized by profit to engage in the arbitrage opportunity.
For example, let’s say that the total value of the S&P 500 stocks is currently $21,000 on the open market. (I’m pulling this number out of a hat). If the proportionate value of SPY shares were trading at $20,000, an authorized participant might want to step in and buy shares of the ETF. They could spend $20,000 buying the ETF shares, then turn around and destroy them in exchange for the underlying S&P 500 equities. They’d then be free to sell the group of securities for $21,000 on the open market, pocketing $1,000 in the process.
The reverse is also true. If the ETF were trading for $21,000 but the underlying securities valued at $20,000, an authorized participant would be incentivized to step in and buy the individual companies. They’d then package them together into shares of the ETF, sell those new shares, and pocket the $1,000. This activity would put upward pressure on the underlying companies and downward pressure on the ETF, narrowing the gap between the two.
This arbitrage activity is precisely what makes the ETF structure work. Since intra-day pricing for ETFs is purely influenced by supply and demand, fund price tends to deviate a bit from net asset value. When the price strays too far, authorized participants take advantage of the opportunity by intervening, bringing that deviation back down.
ETFs vs. Mutual Funds
As you can see, this is quite a bit different from how a mutual fund operates. It’s worked quite well in the 25 years ETFs have been in the marketplace. But that doesn’t meant ETFs are perfect. As good as the authorized participant system has worked, there’s a substantial risk of what might happen to ETFs if the authorized participants were to step away from the market and not participate in the pricing arbitrage. Without that group creating and destroying shares of ETFs to minimize deviations from net asset value, there’s potential for wild swings in premiums & discounts.
Granted, the larger the deviation, the more incentive there for authorized participants to step in. But even so, authorized participants need to have the cash on hand to engage in the arbitrage. Back in 2009 during the financial crisis, many didn’t have sufficient capital to participate. This is a risk ETF investors need to be aware of.
In general, ETFs are a bit more tax efficient than mutual funds. But as with most topics related to investing, it depends on the situation.
The reason comes down again to the differences in structure. Mutual fund managers take in dollars from investors in exchange for shares in their fund based on the NAV at the end of the day. You give $1,000 to a mutual fund manager, they figure out what each share is worth based on end of day prices, then give you a proportionate number of shares of the fund.
When investors want to redeem shares, the mutual fund manager is compelled to shell out cash to investors in exchange for the share redemption. This can pose a tax problem for mutual fund managers. When sell/redemption requests come in, managers will often need to sell securities in the portfolio to raise the required cash to pay back investors. If those sales occur at a gain, it will be taxable to the mutual fund.
Mutual funds don’t pay taxable gains themselves, though. Instead, they pass on gains, dividends, and other distributions back to the fund’s shareholders. For shareholders, this means that your fellow mutual fund investors can trigger tax bills that you end up paying. If everyone else invested in the fund sells, the manager is going to need to raise cash to meet the redemption requests. When that causes a net capital gain to the fund, you could be in for a tax bill if you still own the shares when that gain is distributed. (You can sometimes liquidate the holding before being issued the gain).
ETF Tax Efficiency
ETFs are a different animal. Remember that ETFs are created and destroyed by authorized participants. Which only occurs when there’s a reasonable arbitrage incentive.
Purchases and sales by other investors in the same ETF don’t directly impact you. Since these transactions shift ETF ownership from one person to another (rather than creating new shares every time a new investor gives the manager money), sales don’t require the manager to raise any additional cash.
Mutual fund managers can use their structure to their advantage too, though. Whereas they’re required to distribute gains to shareholders as they occur, losses can be carried over in future years to offset them. Which in practice serves to dampen the tax blow.
Side by side, ETFs are typically a bit more tax efficient than mutual funds. That’s a generalization though. The key is to understand what you’re trying to invest in, what type of account you’ll be investing in, and make a reasonable decision based on your objectives.
There’s a lot to be said for convenience when choosing between ETFs and mutual funds too. On one hand, mutual funds are handy because you can purchase exact dollar amounts of the fund you want to pick up. You give a mutual fund manager $1,000, 100% of that money will be invested in the fund. Mutual fund purchases look “clean” in your account too, when every last penny is invested just the way you want it.
Mutual funds are less convenient when it comes to tax loss harvesting. For example, let’s say that you bought your stock fund in February of 2020, right before the Coronavirus market crash. If you paid $1,000 for the shares, and then immediately saw them fall to $750, you might want to sell them to lock in the loss for tax purposes. Which in general is a great idea if you’re investing in a taxable account.
In doing so you’d tell your mutual fund manager that to redeem 100% of the shares you own. That manager would then calculate the fund’s NAV (like they do every single trading day), and give you whatever the shares are worth based on that day’s value.
Here’s the problem: you won’t know exactly how much cash you’ll get in return for your shares until after the trading day closes.
You may not want to stop investing in stocks altogether if you’re simply selling to harvest a loss. You probably just want to sell the fund you own at a loss for tax purposes, and may want to use the proceeds to invest in something similar. That way you can book the tax loss without altering your portfolio too much. But since you don’t know exactly how much money you’ll be getting for your shares, you’re forced to wait one day to reenter the market. Which is not ideal.
ETF Trading Efficiency
ETFs are a little easier to trade in and out of. You buy and sell at a specific market price throughout the trading day, and know exactly what you’re paying in a buy or what you’re getting in a sale. Which makes it quite a bit easier to sell a position for a tax loss and immediately invest the proceeds the same day.
My only criticism of ETFs from a trading standpoint is that it’s a little more challenging tough to use 100% of the cash in your account. If you select a stock ETF trading at $25 to invest $1,000 in, you’d be able to buy exactly 40 shares. But if that ETF trades at $26, you’d only be able to buy 38 shares. The extra $12 cash ($1,000 – ($26 * 38)) would sit idle in your account.
Admittedly, this limitation may be going away sometime soon. It’s only a issue now because most brokerage firms do not allow for fractional trading. You can buy 38 shares, 39 shares, or 40, but you can’t buy 38.5. There are some brokerage firms (Robinhood) that do allow fractional trading, and my guess is that in 5-10 years it will be commonplace. But at the moment it’s a minor drawback.
How to Know Which Is Best For You
Mutual funds and ETFs can both be a wonderful way to build a portfolio, but the best choice for you will depend on the circumstances. Here’s a quick breakdown of criteria I’d look for:
When to Consider Mutual Funds
- You are investing in a retirement account and have no need to harvest losses
- You don’t plan to rebalance frequently
- You want to invest in a non-traditional asset class
When to Consider ETFs
- You plan to trade frequently
- You are investing in a taxable account and plan to harvest losses
- You are investing in ordinary stocks, bonds, and real estate investment trusts
The marketplace has become far friendlier to every day investors over the last decade or so, and I expect that trend to continue. Just remember that you probably don’t want to change horses too much mid-race. A little homework at the beginning to make an informed choice can go a long way over time.