The investment management business is a highly competitive industry that changes, adapts, and evolves over time. Over the years, individual investors have benefitted tremendously from many of these changes. We see trading commissions have declined toward zero, management fees and mutual funds expenses have been reduced sharply, and access to up-to-the minute market information is available to anyone with a computer or smart phone. Perhaps most amazing, we have found that software algorithms now routinely design low-cost, tax-efficient, highly diversified portfolios in just a few minutes for retail investors through several online platforms. It feels like we are living in the golden age of personal investing.
Another example of this evolution was the introduction of Exchange-Traded Funds nearly thirty years ago, in 1993. A bit slow to take off initially, this product has exploded in popularity in the last decade or so and now accounts for $6.6 trillion in managed assets across more than 2,500 different funds. But despite an annualized growth rate of 26%, we see that the ETF industry is still dwarfed by the U.S. mutual fund complex, which holds more than $21 trillion in assets across 7,600+ individual funds. However, the total number of U.S. mutual funds peaked in 2001 at 8,268 and has started to decline in the last few years. Some mutual funds are even choosing to ‘convert’ to an ETF structure. Experts believe that the total size of the ETF market is on track to surpass mutual fund assets before the end of this decade.
So, what exactly is an “Exchange-Traded Fund” and how does it compare to a “traditional” mutual fund?
Let’s start with the similarities. Both ETFs and mutual funds represent pooled assets from multiple investors that are invested together to achieve a particular investment strategy or goal. They can be highly concentrated in just a few holdings or widely diversified across thousands of individual securities. They can be actively managed, or they can passively target a certain index. Nearly all mutual funds and ETFs charge a management fee to holders of the fund. And both kinds of funds can used as building blocks to design an optimal portfolio.
There are some notable differences between the two products, however:
- Exchange-traded funds trade throughout the day, like a common stock on an exchange. The price of an ETF will fluctuate minute by minute, so buying and selling an ETF is somewhat more involved than placing an order for a mutual fund. In contrast, a mutual fund trades once at the end of each day, and all investors that day receive the same price, also known as the “Net Asset Value” or NAV.
- ETFs can trade at premiums or discounts to their underlying fund holdings. The prices of open-ended mutual funds (those that are still accepting new money), however, are always set equal to the value of their net assets.
- Operating expenses tend to be lower, on average, for ETFs than for mutual funds, although this partially reflects the fact that a larger proportion of mutual funds are actively managed. Many ETFs are passively managed (or “indexed”) and may charge very low fees of just a few basis points (hundredths of a percent) per year.
- The structure of ETFs can allow for much greater tax efficiency than traditional mutual funds. Through the use of “authorized participants” (typically a large partner bank), ETFs can streamline the share creation and redemption process without triggering realized capital gains.
- Mutual funds can be purchased in fractional shares, which allows dollar-cost averaging (DCA) strategies or periodic (scheduled) investments to work well even for relatively small dollar amounts. ETFs, however, must be purchased in whole share amounts, the smallest unit being one full share.
Given these differences, which one is right for you? The answer really depends on your particular investment goals. If maximum tax efficiency is your goal, ETFs can certainly offer an advantage in that area. ETFs are also probably the cheapest way to target a particular index today. But ETFs may not be ideal for other investors who are more interested in a particular strategy or asset class that can be hard to find outside of a traditional mutual fund. Mutual funds also offer a simplified buying process that doesn’t require you to watch market price movements throughout the day.
Where is this all leading? ETFs may one day become the dominant platform for retail investors to access the markets, but in the short term, ETFs are likely to co-exist with the much larger and more established mutual fund industry. This means that today’s investors can choose the type of fund that best matches their goals, or even build a portfolio that includes both vehicles. And ongoing competition between fund types should continue to drive down costs, broaden access to the investment markets, and improve overall investment experiences.