A common conclusion to the mutual fund vs ETF debate is: “ETFs good. Mutual funds bad.” However, reality is much more nuanced than that.
Mutual funds and ETFs are both ways that investors can buy a single unit of the fund to gain access to partial ownership of many companies, bonds, or even exposure to commodities. They make diversification simple and more cost-effective compared to buying into those assets individually.
While they both serve this role, mutual funds and ETFs have a different structure. Subtle differences may have important implications for your situation. ETFs and mutual funds are also not homogeneous. Learn how to spot characteristics that determine whether a mutual fund or ETF aligns with your investing strategy.
Buying & Selling ETFs vs Mutual Funds
ETF Share Construction & Liquidity
Buying an ETF unit or a mutual fund unit represents a small ownership stake in all the different holdings of the fund. For an ETF, you buy or sell that share directly, in real time, on an exchange (e.g., Toronto Stock Exchange in Canada or the New York Stock Exchange in the US). That is the obvious part, but there are three layers beneath the surface that make ETFs very liquid to buy and sell.
You may be buying shares directly from another investor who is selling. Market makers may also create units for the ETF provider if needed. Rebalancing can also be done through making exchanges “in kind” with market makers rather than buying and selling. That may be more efficient than buying and selling to rebalance like a mutual fund manager does by keeping capital gains within the fund close to zero and reducing trading costs.
Usually, you can only buy whole units of an ETF. For example, if you want to buy $100 of an ETF that costs $30/share, you could buy 3 shares and would have $10 of cash left over. This may not matter when you have large purchases, but for a small one like this example it does. Some providers, particularly those targeting entry-level investors, facilitate the ownership of partial shares at their brokerage to overcome this issue.
Mutual Fund Unit Construction & Liquidity
In contrast, mutual fund units are bought and sold at the end of the trading day. You put an order in to buy a certain value of mutual fund units. At the close, the mutual fund holdings are valued, and the unit price is determined. You get whatever number of units that dollar value you specified can cover the price of. This includes fractions of a unit down to many decimal places.
So, mutual funds may have an edge for those investing small amounts of money at a time. However, it is also common practice for mutual funds to require a minimum investment. For example, a minimum of $500 for the initial investment and a minimum of $50 for subsequent investments.
Most mutual funds are open funds. This means that the provider uses cash flow from net money coming in to buy the stocks or bonds to build units. They sell to get cash when there are net unit redemptions. The trading costs and capital gains are shared across the unit holders.
Transaction Costs
The transaction costs to buy and sell ETFs are pretty transparent. You buy and sell them directly on an exchange using a brokerage. With a discount brokerage, that fee is usually under $10. Maybe even free. There is also a hidden transaction cost in the bid-ask spread. That is a profit the market makers get for providing liquidity. Most ETFs are highly liquid with negligible bid-ask spread. However, some less liquid ETFs may have a bid-ask spread of 0.1% or so. It is hard to quantify, but there are a few best practices you can use to avoid market-maker shenanigans.
Mutual funds are only sold via licensed dealers. That can still be done through a discount brokerage for fees similar to those of trading ETFs. However, the sales costs may be buried in the fund costs at other dealers. This is done by using different mutual fund series, and the cost is buried in the management expense ratio (MER).
Mutual Fund Series
Mutual funds can come in different “series”. These fund series will share the underlying investments. However, they have different management costs and are sometimes set up to make distributions differently. Mutual fund providers can name a series whatever they want to, but typically, they use the nomenclature below.
A-Series (Retail)
These mutual funds are typically sold via a “free” advisor, like at the bank. It is not free, there is an upfront commission and usually an ongoing trailer fee paid to the advisor. This is reflected in a higher MER.
Many of the A-series mutual funds sold at banks are also proprietary. That means that they cannot be transferred and held at other institutions.
Having to sell and realize capital gains or pay early redemption penalties is often used to scare clients away from leaving. However, the savings from moving to a better investment strategy usually easily overcomes the cost of leaving. Use some of the money you save to buy them some Kleenex.
The high fees (commonly 1.5-3%/yr) and sticky traps of A-series mutual funds are what give mutual funds a bad name.
D-Series (Discount)
This is the mutual fund series sold at discount brokerages. There is no advisor cost and trailer fees are now banned in Canada for this type of fund. So, they typically have much lower MERs (0.2-1.75%/yr). That is still a significant range.
F-Series (Fee-based)
A fee-based advisor (the kind that charges a % of assets under management) will typically use F-series funds. Since you are paying your advisor directly and these funds don’t typically have trailer fees, the MER is lower than A-series. To know the total cost of your financial advice, you must at the advisor fee plus the weighted average of the MERs of the underlying funds together.
I-Series (Institutional)
The MER for I-series funds is typically minuscule. That is because they are only available to investors buying massive amounts. Like institutions, pensions, or high-networth individuals.
T-Series
In addition to using a series to separate different compensation models for a mutual fund, a different series can be used to change distributions. For example, some mutual funds have a T-series that typically pays out regular distributions to the unit holders to use as income. That isn’t magical. The money comes from interest, dividends, and capital gains within the fund. However, instead of paying out the distribution as taxable income, it pays some as a “return on capital” (ROC).
That means returning some of the money that you invested. There is no tax on that ROC, but it does mean that your “cost base” for owning the investment decreases and there will ultimately be a larger capital gains tax bill when your units are sold. It is an effective tax deferral strategy but does come with the potentially higher cost of using mutual funds.
Shifting Between Series
The T-series mutual fund also highlights one of the advantages of mutual funds over ETFs – the ability to shift between series without realizing a capital gain. To be clear, you cannot switch from one fund to another. However, you can switch between a series of the same fund like from the regular series to a T-series, without triggering capital gains. The classic reason to do this would be to switch from your saving years to drawing income using the T-series of a fund.
There are ETFs that can automatically distribute a targeted monthly income. For example, BMO ETF’s ZGRO.T has the same underlying asset allocation that ZGRO has. However, ZGRO.T and ZBAL.T target a 6%/yr distribution. That is made up of the interest and dividends and sells what is required to top it up. A convenient way to get regular income without losing the diversification and tax efficiency of an all-in-one asset allocation ETF. In contrast to mutual funds, switching from ZGRO to ZGRO.T would require you to sell one and buy the other, triggering capital gains or losses.
Fund Trust vs Corporate Class Structure
The structure of a mutual fund or ETF impacts how it handles investment income. A mutual fund trust passes all income through, and it is attributed to the unit holder. In contrast, a mutual fund corporation can manage income. It can mean tax-efficient capital gains rather than interest or dividend distributions if managed well. If not managed well, there are high taxes within the fund that directly decrease the unit value. Both ETFs and mutual funds can have either structure.
Mutual Fund Trust
Both ETFs and mutual funds most commonly have a “mutual fund trust” structure. As a trust, the fund holds the stocks or bonds “in trust” for you. An important implication of that is that the trust must pay out income (net of expenses) to you each year. If not, then there would be major tax consequences to the trust. So, if a mutual fund trust receives 1%/unit as a dividend and has 0.1%/unit in fees and costs, it must pay out 0.9%/unit.
The other implication of a trust is that if the fund provider went bust, the funds would still hold your underlying assets to be distributed.
Mutual Fund Corporation
A “corporate class structure” is different. In corporate class, each fund is a share class in a company (mutual fund corporation). As a company, the income received is not directly passed through. It becomes part of the company’s income. Business income can be offset by expenses. The goal of a family of corporate-class ETFs or mutual funds is to use the expenses of running the funds to offset income. For example, the costs of an expensive actively managed fund can be used to offset the income of another fund.
If the company as a whole has no income, then there is no tax, and it does not have to pay out dividends. The value of the shares just increases. Functionally, this changes interest and dividend distributions to capital gains. Capital gains are only taxed when the shares are sold (not annually) and at a lower rate. However, if a mutual fund corporation has net income, that income gets taxed punitively. So, corporate class funds require significant expenses to remain tax efficient. The inability to do that has resulted in many corp class fund closures. It is a management risk.
The leading Canadian corporate-class ETF family is from Global X (the company formerly known as Horizons). They manage income using swaps and have some runway due to opportunistically booking losses. I have made an in-depth analysis of that elsewhere.
Active Management vs Passive Indexing
People often equate active management with mutual funds and passive indexing with ETFs. That has traditionally been how it has played out. However, the reality is that there are also active ETFs and more passive mutual funds. The management strategy is not dependent on the structure. Further, the management strategy and associated costs are probably more important than whether it is bundled as an ETF or a mutual fund.
Active Management
An active strategy uses a manager to try and select the best holdings and when to buy or sell them. So, stock picking and market timing. For actively managed funds to sell units, they must convince investors that the manager will provide them with excess returns. That may be why it is more common amongst mutual funds. A-series funds, in particular, are sold through advisors who are paid to sell them. Many fee-based advisors also still put clients into active F-series mutual funds because they believe active management is beneficial. They may even feel choosing them is their value proposition (I think it isn’t – I think advisor value is in advice, tax planning, and fostering good investor behavior).
Despite the grand narratives used to sell actively managed products, the data does not support it. Markets are so competitive and efficient that this is hard to do effectively enough to make excess profit, net of fees. SPIVA has plenty of data to show that >90% of active managers trail indices. Further, you also cannot pick the ones who do beat markets based on past performance – good performance is not persistent. The tax inefficiency from turnover in an active mutual fund makes it even worse. Higher fees are also associated with worse performance. This is most apparent in the most efficient markets.
The cost of management is key for fund performance. Above is an example from an older Morningstar study, but the details show that relationship nicely. Active ETFs may generally have an advantage over active mutual funds if they have lower costs. Conversely, well-managed and low-cost mutual funds also exist. For example, Dimensional Fund Advisors (DFA) mutual funds have MERs in the 0.15-0.4%/yr range. That is comparable to ETFs. They also use an evidence-based quantitative approach rather than more arbitrary strategies.
Passive Index Tracking
There is no such thing as totally passive investing. There have been decisions made. For example, with an index, someone decides what the inclusion and exclusion criteria are. Even with cap-weighted indices, who decides what the cut-offs are? Some indices, like the S&P ones, even have a committee component. Passivity is a matter of degree. That said, implementing an index approach requires less ongoing research and trading than “active” strategies. That means lower fees, trading costs, and tax implications.
Basically, you accept that markets are efficient enough that you cannot beat them. So, you minimize your losses and try to match them as closely as you can. Again, historically >90% of active investors fail to match their index in a given time period. Win by not losing. Even a passive ETF or mutual fund does not usually match its index perfectly. There is some tracking error. However, it is usually so small as to be a nothing burger.
Choosing a Mutual Fund vs ETF
It is not being a mutual fund or an ETF that makes a fund a good or bad option for an investor. It is the characteristics of the fund. Some are more important than others.
Primary Consideration: Fund Cost & Associated Advice
A-series mutual funds are known for their high fees because that is how the sales advisors are paid. D-series and F-series mutual funds usually have lower fees, but may still be higher than most ETFs. The value that the advisor provides to your specific situation must be weighed against the cost. There are also fee-only or even discretionary full-service advisors who use low-cost ETFs.
Primary Consideration: Fund Cost & Strategy Benefit
An active strategy costs more and is not usually associated with better outcomes. There are actively managed ETFs that have high fees. It is not just a mutual fund characteristic. Further, no strategy is truly passive. However, a broad index-tracking strategy is usually lower cost and has fewer costs and taxes from turnover. Even with a “passive” strategy, the ETF structure may have a slight advantage with less capital gains from rebalancing within the fund due to exchanges “in kind” with market makers.
The importance of strategy is not just about the cost. The main advantage of a fund is easy diversification. Diversification is one of the key investing concepts for building a successful investment strategy. Using a mutual fund or ETF that focuses on a small niche of the market is not diversified. For example, an ETF covering Canadian banks may only have six holdings. Plus, their performance is highly correlated.
Quantitative strategies, like factor investing, present an interesting conundrum. There is academic research to suggest that historically, there have been return premiums for focusing quantitatively on certain stock characteristics. That is less diversified by definition. It also requires ongoing analysis and management. The key is in the implementation. A strategy and methodology that selects those characteristics effectively at a low cost and with a low implementation cost is vital. So, it is very fund-specific and not easily analyzed by the average investor. We’ll have to unpack that further in future posts.
Secondary Consideration: Fund Structure & Taxes
Another feature that may drive cost is a trust vs corporate class structure. A corporate class structure is more expensive whether an ETF or mutual fund. Managed well, that may be worth it to a high-income or incorporated investor due to the tax advantages. However, corporate-class funds are notoriously difficult for their providers to keep viable over the long run. If the fund corporation has net income, it becomes tax-inefficient.
Secondary Consideration: Convenience
While the cost and how effectively a fund implements its investing strategy are the primary considerations, the differences in the convenience of using an ETF vs. a mutual fund could be a secondary consideration.
An ETF is obviously better for someone looking to buy or sell in real-time within a trading day. A mutual fund only trades at the end of the day. However, day trading is more gambling than investing. Even though we are naturally drawn to it. The high liquidity of ETFs is attractive. However, it can also be hazardous if abused.
Both ETFs and mutual funds may be free to buy and sell depending on the fund and brokerage. Even if not free, the cost is generally low enough that it would not be a major factor unless you are making small, frequent transactions. You might choose one over the other based on what is being used by the advisor or brokerage that you are using. I am a strong advocate of DIY investing, and ETFs are great for that. Even if using an advisor, you must learn about the basics of investing to spot a good one. Still, some people benefit more from an advisor. The value should be from their support and advice. The best advisors recognize that and choose mutual funds or ETFs with a low-cost and effective strategy. They are just tools.
Good reminder. I knew about the underperformance of active management long term but still decided to go with it. It was good for a decade, but significantly under performed this year and is at the 95th percentile. Now, I am worried about it underperforming over the long run. Sign….
Great article Dr. Soth, excellent overview.