August 23, 2018. By J.D. Wolfsberg:

No one can accuse the financial world of being predictable. As the landscape continuously changes, so do the investment vehicles and products offered.  Many investors feel they are better off purchasing a fund or ‘basket’ of securities rather than purchasing individual stocks, effectively competing against those with expansive expertise in the markets.  There are certainly benefits to owning these baskets of securities, but which vehicles are best suited to meet an investor’s personal objectives? The most common are Exchange Traded Funds (“ETFs”) and Mutual Funds.   Much of our time is spent on investor education with our clients.  We believe it is important that investors understand and have a general comfort level with the vehicles used.  One of the most common questions we receive is, “What is the difference between an ETF and a mutual fund?”

Like a stock, an ETF is priced by supply and demand and traded on an exchange throughout the day, however instead of investors buying many stocks individually they are purchasing a basket of securities through a single transaction.  Compared to a mutual fund, which also holds a basket of securities, an ETF is more tax efficient. If an investor wishes to sell shares of an ETF, they would simply sell it on an exchange and receive the current market price.  The net gain or loss realized using an ETF strategy is the differential between the original purchase price and the sale price.   If an investor wishes to sell (redeem shares) from a mutual fund, the manager of the mutual fund must sell the underlying securities in order to allow the investor to redeem the value of their shares. This activity creates a taxable event: As shares of the underlying securities are sold, the capital gains taxes are inevitably passed through to the mutual fund holder via lower returns, on top of the capital gains tax taxed directly to the investor at the fund level.  This is why at year-end you may often see capital gains distributions flow to you on your statement and tax documents from your custodian.  The capital gains are distributed to all underlying shareholders regardless of whether the investor personally sold their position or is holding it in their portfolio.  While these capital gains are distributed to shareholders many often reinvest the proceeds to purchase additional fractional shares however, you are still taxed on the capital gains.

In addition to the related tax implications, an investor will want to determine whether she is looking for passive equity exposure or active equity exposure. If passive, an ETF may be the better choice.  ETFs that replicate an asset class or sub-asset class may be more cost effective than a mutual fund. Passive, ‘beta’, exposure allows an investor to focus on gaining broad market exposure while minimizing costs and optimizing tax efficiencies.   On the other hand, if the investor is seeking active exposure, the search becomes less about broad asset class exposure, and more about the portfolio manager and the investment style of the fund. Regardless of the vehicle, those actively attempting to outperform the market will assess higher fees.  As the industry currently stands, the vast majority of active managers are primarily accessible through mutual funds rather than ETFs.  Therefore, if an investor is looking for active exposure, it may make sense for them to look toward mutual funds.

There are benefits and drawbacks to both types of vehicles. Investors must keep in mind the associated costs, benefits, and as the type of exposure they are looking for whether broad market or active management.  As this article serves as a brief overview of each, we are happy to answer any further questions our clients may have about how mutual funds and ETFs fit into a diversified portfolio and strategic investment plan.