Not all EFTs are created equal. There are well over 2,000 different ETFs in the market. And then there are also Mutual Funds. It’s very easy to feel overwhelmed. In this post, we are focusing on the pros and cons of ETF vs. Mutual Funds. We are also discussing some recent trends and statistics about ETFs.
The number of ETFs in the United States has steadily risen since 2003. In December 2022, the total number of ETFs reached 2,844. ETFs represent 12.6% in the U.S. of all the stock and equity held. Given those numbers, learning more about that topic makes sense.
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What is an ETF?
If you are new to this topic or area of investing, you might need to learn what exactly an ETF is. First of all, ETF stands for Exchange-Traded-Fund. Think of it like an investment into a pool or collection of companies. Instead of investing directly into a single company, you spread your investment across all companies in that pool.
Besides companies, ETFs can contain other securities like currencies, commodities, etc. Behind an ETF, there is also a company that manages it. Some ETFs are managed actively, meaning a set of experts behind the ETF tracks the market and does research. They will change the allocation of the pool occasionally to improve your returns. And there are passively managed ETFs. Those ETFs track an index like the S&P 500. The S&P 500-tracking SPY was the very first ETF in the market. There are some differences to keep in mind between actively and passively managed ETFs, but more on that later.
What is the difference between ETF vs Mutual Funds?
Before discussing their differences, let’s look at what they have in common. Both represent a pool of individual securities like stocks or bonds. Thus, they are, by definition, both great tools for portfolio diversification. Also, both are passively or actively managed.
There are so many similarities! It’s the same thing!?!
Well, not quite!
The first difference is the way you can trade them. Mutual Funds are only traded once per day. Every order that is processed on the same day receives the same price. You cannot buy and sell Mutual Funds during market hours. ETFs, on the other hand, behave very much like stocks. You can trade them during market hours.
Another difference is the tax efficiency. Since both types of investments undergo some adjustments over their lifetime (done by the management company or the fund manager), they create capital gains. ETFs use a process called in-kind creation/redemption as a way to maximize tax efficiency and, thus, minimize capital gains distributions. It is in fact, this little detail that makes ETFs more attractive for investors.
Let’s talk about the fee structure for a moment. Both ETFs and Mutual Funds come with a fee. For Mutual Funds, this includes a so-called 12b-1 Fee. That fee is your share of the marketing, advertisement, and distribution cost of the Mutual Fund. ETFs tend to carry smaller fees than Mutual Funds because they require less hands-on work. Over the years, the difference in fees has come down.
Actively and Passively managed ETFs
Choosing the right ETF for you isn’t easy. The first question you need to ask yourself is what ETF management style you’d prefer.
You differentiate between actively and passively managed ETFs. The management style impacts the fees you pay, tax efficiency, and risk profile.
An actively managed ETF is best if you want to invest in a specific strategy or industry. Passively managed ETFs or Index ETFs, on the other hand, provide more stable long-term results.
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Actively Managed ETFs
The market of Actively Managed ETFs in the U.S. is rising. This type of ETF usually comes with higher fees since a team of experts is making sure to maximize the returns of your ETF investment. They do market research, adjust the ETF holdings and all that costs money you are paying in the form of fees.
The average expense ratio for actively managed Stock ETFs 2022 was 0.69%. Let’s take a look at a simple comparison:
| Expense Ratio: 0.5% | Expense Ratio: 0.75% | Expense Ratio: 1.0% | |
|---|---|---|---|
| Initial Investment | $10,000 | $10,000 | $10,000 |
| Expected annual investment return | 10.0% | 10.0% | 10.0% |
| Duration of Investment | 10 years | 10 years | 10 years |
| Future value of Total investment | $24,782.28 | $24,222.25 | $23,673.64 |
| Total cost of ETF | $1,155.15 | $1,715.18 | $2,263.79 |
As you can see, the total cost of an ETF can be drastically different based on the expense ratio. But it’s not just the higher fees that you are paying. That money would also continue to grow if you didn’t have to pay in the first place. The compounding effect of a 0.1% smaller fee is sometimes tough to imagine. It’s just one of the many examples of why humans are, by definition, no good investors (exceptions may apply 🙂 ).
Some examples of actively managed ETFs (as of July 2023):
- ARK Innovation ETF (ARKK) – Expense Ratio: 0.75%, Year-to-Date Return: 41.29%
- Dimensional World ex U.S. Core Equity 2 ETF (DFAX) – Expense Ratio: 0.30%, Year-to-Date Return: 12.48%
- Grayscale Future of Finance ETF (GFOF) – Expense Ratio: 0.70%, Year-to-Date Return: 114.57%
Pro Tip 💰
Since most actively managed ETFs aim to outperform the market, a good starting point when choosing the right ETF for you is how they performed compared to the market. Over 87% of actively managed ETFs have lagged their intended benchmark, making this research even more essential! (source: Forbes Advisor)
Passively Managed ETFs
Because passively managed ETFs are much easier to manage, they usually have much lower fees. The average comes in at around 0.16% in 2022.
| Expense Ratio: 0.05% | Expense Ratio: 0.15% | Expense Ratio: 0.25% | |
|---|---|---|---|
| Initial Investment | $10,000 | $10,000 | $10,000 |
| Expected annual investment return | 10.0% | 10.0% | 10.0% |
| Duration of Investment | 10 years | 10 years | 10 years |
| Future value of Total investment | $25,819.77 | $25,585.89 | $25,353.93 |
| Total cost of ETF | $117.66 | $351.53 | $583.49 |
Conclusion – ETF vs Mutual Funds
Done the right way, Mutual Funds and ETF Investing can add much value to your portfolio. They provide a more hands-off approach to investing since you outsource the responsibility to track the market. ETFs have been on the rise in recent years for reasons like tax efficiency, but the choice of ETF Investing vs Mutual Funds comes down to your preference and research using the tips from this post.
You should reevaluate your investments from time to time. But following an ETF or Mutual Fund as closely as you would follow an individual company isn’t required.
Whether you are searching for a relatively safe long-term Index ETF that can reasonably outperform the market or just want exposure to an area like crypto, finance, healthcare, or any other smaller market. There is an ETF for almost everything! You have to do your research and find the right ETF for you.
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