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What is an ETF? ETFs are fast becoming one of, if not the most, popular investment instruments for both individual and institutional investors.
After being introduced in the United States as recently as 1993, assets under management (AUM) in the ETF industry crossed the $2 trillion mark in 2015. It’s no wonder more and more individual investors are asking what is an ETF?
Considering that the AUM in 2012 were just over $1 trillion, it’s easy to see that the growth in recent years has been exponential. A large majority of financial analysts agree that this growth will continue.
It’s good for individual investors to understand what exactly ETFs are and how they are different from mutual funds or single stocks.
What is an ETF?
ETF is short for: exchange traded fund. The textbook definition of an exchange traded fund is:
“An investment company designed to track a specific index that is traded on a stock exchange. Rather than basing the price on net asset value (NAV), the ETF’s market price is constantly changing as does the price of any other listed stock. ETFs may be purchased on margin and sold short.”
To put this in plain language, an ETF is a fund which allows investors to buy multiple securities (e.g. stocks, bonds, real estate, or commodities) at one time. The fund is bought and sold in its entirety, rather than the underlying assets being traded individually.
This sounds a lot like a mutual fund, but there are stark differences between the two. Before getting into how an ETF works, let’s define a mutual fund. We can then contrast the two.
What is a Mutual Fund?
When discussing mutual funds in this article, we are referring to open-end, as opposed to closed-end, funds. The textbook definition of an open-end mutual fund is:
“An investment company that continuously offers new equity shares in an actively managed portfolio of securities. All shareholders participate in the fund’s gains or losses. The shares are redeemable on any business day at the net asset value (NAV). Each mutual fund’s portfolio is invested to match the objective stated in the prospectus.”
As with an ETF, a mutual fund provides an opportunity for investors to easily buy and sell a large number of securities at one time. But, the parallels pretty much stop there.
The major differences between an ETF and a mutual fund are related to:
- Liquidity
- Fees & Expenses
- Taxation
Let’s compare and contrast…
Differences In Liquidity
As the name indicates, an ETF trades on a stock exchange. This allows investors to buy and sell shares on a secondary market without getting the fund company involved in the transaction.
An ETF can trade hands in a fraction of a second at any time on the open market.
Mutual funds do not trade on an exchange. If an investor wants to buy a mutual fund, the fund company must offer new shares directly to the interested investor.
Likewise, when a shareholder wants to redeem shares of a mutual fund, the fund company must sell the underlying assets in the fund and return cash to the investor.
Differences In Fees & Expenses
Both ETFs and Mutual Funds can be either actively managed or passively managed.
A passively managed fund closely follows a benchmark – such as the S&P 500 or Russell 2000. An actively managed fund selects investments based on specific criteria.
While passive funds are always cheaper than active funds, an ETF will always be cheaper than a mutual fund when comparing apples-to-apples.
Actively managed mutual funds are run by fund managers who utilize a team of analysts to carefully select the underlying securities. By contrast, actively managed ETFs follow quantitative algorithms to select and allocate investments.
It makes sense that an ETF would be cheaper than a mutual fund in this case, but are passively managed mutual funds really more costly than passive ETFs?
The Vanguard SP 500 Index Mutual Fund (VFINX) has an expense ratio of 17 basis points. This means Vanguard charges shareholders 0.17% of total assets each year for administrative expenses.
The Vanguard SP 500 ETF (VOO) charges only 5 basis point. This means the administrative costs for a passive mutual fund are 3X more expensive than an ETF with the exact same benchmark. Why?
ETFs are cheaper for the same reason they are more liquid. They trade on a secondary market. When an investor wants to buy or sell a mutual fund, the fund company needs to directly offer or redeem the shares.
With ETFs, the shares are traded on an exchange without the fund company needing to get involved in the transaction. This eliminates a large portion of operational and administrative costs.
Differences In Taxation
When a mutual fund realizes a gain by selling a security which has increased in value, the shareholder is required to pay capital gains tax. An investor in an ETF is not required to pay tax in the same scenario due to what’s called in-kind redemption tax rules.
This is a pretty complicated matter, but essentially, the ETF is able to honor creation and redemption requests through stock-for-stock transactions. A mutual fund on the other hand, rebalances through stock-for-cash transactions.
By avoiding both short-term and long-term capital gains tax while holding the fund, an ETF investor will see exponentially superior returns over several years.
A Third Alternative
Whether an investor wants a passively or actively managed fund, the pros and cons for ETFs vs. mutual funds are clear.
There is however a third alternative for investors looking to build wealth in the stock market. Individuals can compile their own portfolios by purchasing single-stocks.
This option allows individual investors to avoid fund expenses, while controlling the portfolio’s level of diversification and turnover rate. Investors in single-stocks always have complete control over what they own.
The stock screens available on TheStockMarketBlueprint.com give investors the ability to find single-stock investments based on specific value investing strategies.
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Mitchell Mauer is the Founder of TheStockMarketBlueprint.com. The Stock Market Blueprint is a site that finds value stocks for investors building long-term wealth. The site’s investment philosophy is anchored in principles established by Benjamin Graham and his most reputable followers over the last 100 years.
