Sunday, May 22, 2011

Big Brother, Little Brother- Mutual Funds vs. ETFs

The world of investing never ceases to stop confusing me…It seems as though every time I learn about something new within investing, I always get left with ten new questions about what I have just read. It is truly a vicious cycle. It was the other day that I had just purchased a new mutual fund, when I got to thinking that I also own some ETFs (exchange traded funds.)  Then I also got to thinking that I do not even truly know all the main differences between the two. Through a little research I hope to truly unlock the main differences between mutual funds and ETFs.

For those who don’t want to read a lot, I will break down my conclusions for you right now. Please read on, though, for more explanation if you want to know more. Keep in mind, these findings may vary from fund to fund, but overall my naïve little mind thinks they are pretty sound.

Dividend & Cap Gains Reinvestment
Mutual Fund
Investment Choices
Mutual Fund

Mutual funds have significant seniority to ETFs. The first mutual fund that resembled anything that we see today was called the Wellington Fund. It went public in 1928 and was the first open-ended fund, that’s holdings included stocks and bonds. Open-ended simply means that the funds can issue new shares as they see fit, as well as buy back shares when investors wish to sell. Before that time, property trusts were what investors would invest in to get a “mixed bag” of securities. At this time, there are about 6800 mutual funds, not including the funds who have other sister funds in the same share class.

ETFs hit the scene in the United States in 1993. The first ETFs were the SPDRs (Standard and Poor’s 500 Depository Receipts.) The SPDRs are still around today, one of the more popular ones being the S&P 500 Index (ticker symbol: SPY.) As of April 2011, there are 1038 ETFs.

So the real question is what are the similarities and differences between mutual funds and ETFs? Well, that is a great question. Find out next week for more information….just kidding.
The first criteria I would like to explore are expenses. Surely there will be outliers on the cheap and expensive end for both mutual funds and ETFs, but there is a general average that we can look at.

When you buy a mutual fund, make sure you purchase one that is a “no-load” mutual fund. If it has a load, it means you are paying commission to the broker who sold it to you. You may also be required to pay a transaction fee for buying or selling the mutual fund, so be sure you do some research on costs and fees before you make a purchase. According to Investopedia, the average equity mutual fund has annual expenses ranging between 1.3-1.5%. These numbers represent the percentage of the cut that the house (the fund) will take back to cover its own expenses; for example, paying the fund managers who research which securities to acquire. These expenses can go even higher if you are purchasing an international or specialty fund. They can also go lower if you are purchasing an index fund. Do take expense ratios into serious consideration before purchasing. If a fund has an expenses ratio of 1.5%, you will need to get an annual return on that fund of 11.5% to get yourself a 10% return.

An index fund is a fund who tracks a specific index. I mentioned earlier the SPDR S&P 500 Index, which simply just follows the average movement of all 500 of the stocks that make up that index. There are also mutual funds and ETFs which track the Dow Jones Industrial Average, the NASDAQ, and also sector indexs. A sector index is a fund that will move with the average of a specific sector; for example, I own an ETF called SPDR Select Energy (ticker symbol: XLE.) This fund tracks the average movement of all the energy stocks in the S&P 500 index. So essentially it is an index within an index.

Index funds usually always have lower expenses because they are typically not actively managed. An actively managed fund simply means that a fund manager is behind the wheel, and will buy and sell securities as they see fit, so the fund’s holdings are constantly changing. An index fund is usually not actively managed because it just tracks an index; there is no managing necessary.

ETFs basically have mutual funds beat on expenses hands down. There are not loads on ETFs. You will pay a commission to purchase ETFs to your broker, just like any normal stock because ETFs can be traded intraday just like stocks. So overall, when it comes to expenses, ETFs will take the win.

Another category of criteria I would like to explore is dividend and capital gains reinvestment. If you are deciding between a mutual fund or ETF whose holdings have securities that pay a dividend, you are now stuck in a conundrum.

With mutual funds, when you first purchase the mutual fund, typically you are asked if you would like to reinvest the dividends and capital gains you earn. In most situations, this is a good thing. It is good because you can essentially get more shares, commission-free. The dividends or gains are just added to your total dollar amount invested in the mutual fund.

On the contrary, with ETFs, you cannot get capital gains or dividends reinvested. This is because ETFs are sold as shares. You must pay the current bid price for a share, you cannot purchase a partial block like you can with mutual funds. And when you do make an ETF purchase, you will have to pay your broker a commission.
So depending on your situation, reinvestment can be really handy for you. If you already own the mutual fund, it is implied that it is a fund you like, so owning more, commission-free, is a good thing.
Current scorecard: Mutual Funds-1……….ETFs-1

The next category is liquidity. This is going to be an obvious one, but it should be highlighted anyway for those who do not know.

Let’s say that it is a Monday at noon. If I place an order to buy a mutual fund, I will not see the mutual fund in my portfolio until the next trading day. I also cannot really determine what price I will pay for the mutual fund, because orders are filled at the end of the day, using that day’s ending NAV (net asset value) price. It is doubtful that the price will fluctuate too much, but it is still a valid consideration.

And then there was the ETF. These things are named after their excellent liquidity. They can be traded intraday, at a moment’s notice. There is no waiting for money or no NAVs. You can also use options with ETFs, or short them.

ETFs definitely win the liquidity battle, hands down.

Next up, we have the investment choices category. As I stated earlier, there are currently about 6800 mutual funds. And there are currently 1,038 ETFs…………I think the winner is pretty obvious, but I’ll say it anyway. Mutual funds have more options to invest in different securities.

In conclusion, there are many different factors you should consider before purchasing a fund. As with almost all things finance-related, everybody's situation is going to be different. There is no clear cut winner that I can find in the battle between mutual funds and ETFs. I have not even gone over all the differences between the two if you can believe it. 

The fund world is constantly evolving. ETFs are increasing in number very fast and will one day probably outnumber mutual funds. When they day comes, they may be a better option, but until then, the battle continues...

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