Derek, what is the difference between mutual funds and exchange traded funds?
The investment world isn’t getting any easier to navigate. It seems every week there is a new idea or product that is being introduced.
Most investors are familiar with mutual funds, but exchange traded funds (ETFs) are a relatively new product that are becoming very commonplace. While on paper they may seem very similar, there are a number of significant differences.
Both products appear the same at first glance. In particular, both own an underlying group of assets (such as stock, bonds, bars of precious metals, future contracts, etc). As an investor, when you buy units of a mutual fund or ETF, you are theoretically an owner of whatever group of assets that fund contains. As these positions move up or down, you will see the value in your investment change as well.
Another similarity is that each fund includes one single price to keep track of how much you’ve made or lost. This price is referred to as the Net Asset Value (NAV) and is determined by adding up the value of all the assets in the fund, minus expenses, and then tallied on a per share/unit basis. Alternatively, you could go buy all the individual assets on your own and track the value of each holding, minus whatever your expenses may be. The simplicity of these products is part of what is attractive to investors.
Mutual funds and ETFs both provide a solution to create a diversified portfolio without having to own multiple investments from around the globe. Both investment choices have numerous options available depending on where you want to invest. Some are specific to various sectors (such as oil and gas, telecommunications, or technology), while others are focused on a broad market (such as the Toronto Stock Exchange). Therefore both products could be used to build a diversified investment strategy.
One notable difference is that mutual funds all have a portfolio manager, or a team of managers, looking after the assets.
This compares to an ETF where typically there isn’t a portfolio manager and the investment decisions are following a pre-determined set of investment rules. For example, if you wanted to invest in a portfolio of dividend paying companies in Canada, a mutual fund will handpick what they consider to be the best choices. In comparison an ETF would invest your portfolio equally between all the different dividend paying companies in a certain group. In short, a mutual fund is making educated decisions, while an ETF is following a set of rules.
The lack of a portfolio manager doesn’t make an ETF a poor investment decision. Some investors prefer ETFs because they want specific exposure to an area of the market and want to own all the companies instead of handpicking certain names.
The thinking is that while the portfolio manager in a mutual fund is ideally choosing the right assets, they won’t always be right.
The ETF on the other hand will blanket everything and the idea is that the good picks will outshine the bad picks. The concepts offer two very different strategies when it comes to investing.
To expand off this, if you think the oil and gas sector will recover in the next few years, you could buy a mutual fund that invests in a small grouping of stocks. T
he portfolio manager will then change the portfolio as he or she sees necessary. Otherwise, you could buy an ETF that owns all the major oil and gas companies in Canada by equal percentages. The point being, if you think the entire sector will recover then it may be best just to own all the companies instead of trying to select which may be the winners.
Another significant difference is that the costs of an ETF are usually less than a mutual fund. Because there is no portfolio manager there aren’t as many expenses which tend to reduce the internal fees. Some investors choose ETFs because they are the cheaper option. Cheaper isn’t always better, so this shouldn’t be your only reason for making an investment decision. Keep in mind there is usually a commission to buy or sell an ETF as well.
Finally, ETFs can be bought and sold throughout the trading day whereas a mutual fund transaction won’t take effect until the next day. For some investors this is an important feature. If you want to ability to buy or sell immediately at a certain price an ETF will give you this flexibility. A mutual fund will determine the NAV at the close of the market, and your order will then be processed at that price along with all the other orders that day.
The decision between investing in an ETF or a mutual fund isn’t just about fees, there are many factors in consider. As such, it’s best to have a conversation with an advisor that can direct you accordingly. Happy investing.
Derek Fuchs is a wealth adviser with ScotiaMcLeod in Red Deer, and a certified financial planner, financial management adviser and a fellow of the Canadian Securities Institute. He can be contacted at firstname.lastname@example.org.