Exchange-traded funds versus mutual funds

Pooled investment vehicles have been in existence for over 100 years, but mutual funds ballooned in popularity in the 1980s and 1990s as many “Main Street” investors desired simple, diversified investment options. Today, the global open-end mutual fund market is over $45 trillion in size, with about $21 trillion in the U.S. (source: ICI). More recently, exchange-traded funds (ETFs) have burst onto the investment stage, garnering over $5 trillion of assets as of March 2019 (source: ICI). The rise of ETFs has primarily come at the expense of mutual funds. Many investors are unaware of the similarities and differences between these two types of pooled investment vehicles, so in this article, we’ll explore some of those questions.

What is an ETF?

Exchange-traded funds were introduced in the early 1990s and are pooled investment vehicles that allow an investor to gain broad exposure to a diversified basket of stocks, bonds, or other assets. They are traded throughout the day on an exchange at market determined prices, much like stocks. 

Similarities and differences between ETFs and mutual funds

ETFs and mutual funds both enable investors to pool their money with other investors and gain access to a basket of securities. Exchange-traded funds and mutual funds are registered with the SEC. Both vehicles make it easier for investors to diversify holdings and reduce overall portfolio risk. However, ETFs include some features that distinguish them from mutual funds:

1. Liquidity: ETFs trade throughout the day whereas mutual funds are priced and traded at the close of the market each day.
2. Transparency: The underlying investments in an ETF are disclosed in real time, whereas mutual funds may disclose their holdings on a 60-90 day delayed basis. With ETFs, investors know what they own and the pooled vehicle generally trades at a price that’s close to the market value of underlying securities held.
3. Tax efficiency: Exchange-traded funds generally do not incur sizeable taxable gains like some mutual funds do because of how the ETF shares are created and redeemed.
4. Active management: Most ETFs follow a specific market index or a passive strategy, but mutual funds are often actively managed.
5. Fee rationality: ETFs often have lower fees than mutual funds as most are not actively managed and they generally have lower expenses related to distribution.

ETF advantages

Despite the fact that exchange-traded funds generally replicate passive indexes, they can enable active management of attractive investment opportunities at a low cost and with reliable and continuous liquidity. They also enable investors to gain cost-efficient exposure to the most attractive areas of the global market and provide access to asset classes where it is not time- or resource-efficient to actively manage individual positions. As is the case with many kinds of investments, exchange-traded funds can vary in the quality, liquidity, and leverage of the underlying securities, so we recommend consulting with your wealth manager to determine what is appropriate for your portfolio.