What are the Differences between ETFs and Mutual Funds?

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ETFs are a new incarnation of Mutual Funds, as they both pool investor resources to allow investors to benefit from economies of scale in investing. Such economies of scale would, in turn, enable cost-effective diversification, which is very valuable for reducing risk. We want risk reduction because the discomfort from gaining a dollar less than expected is greater than the joy from earning a dollar above expectation.

Thus mutual funds and ETFs are both designed to satisfy the same need. This similarity between mutual funds and ETFs is so remarkable that some funds structure one of their classes as an ETF, while other classes are different classes of a mutual fund. The main difference is that ETFs are bought mainly by self-directed investors, so no advisor is compensated. Thus ETF investments, on average, cost less than mutual fund investments.

While there are more mutual funds actively managing funds or giving broad exposure to the stock market or bond market, if you want a very specific exposure, for example, if you want to add pure gold exposure or pure oil exposure to your portfolio, you would need to use ETFs.

There are also some technical differences between ETFs and mutual funds. The standard form of a mutual fund is an open-ended mutual fund in which you entrust your money to the fund manager to be used for investment. You might do this by going directly to a fund manager’s website or office or having your advisor or broker do this on your behalf.

In the case of ETFs, they are listed on an exchange similar to closed-end mutual funds and unit investment trusts. You would have no dealing with the issuer; your broker buys ETF units for you on the exchange.

Mutual funds often have a minimum investment which depends on the mutual fund class. The retail investor class might have a minimum investment on the order of $500. But if you are setting up a monthly investment plan, it can be as low as $25. Loads (sales charges) were common amongst mutual funds, but intense competition has changed the scene. If there is a load, it is essential to make sure your investment is significant enough to justify the load.

Theoretically, ETFs do not have a minimum investment, and you can buy as little as a single ETF share. The caveat is that many brokers would charge you a commission for each trade, and you should ensure that the number of ETF units you buy justifies the trade commission you are paying.

Mutual funds have been around in the North American investment industry for almost a century. Mutual funds were often actively managed, while the rise of ETFs coincided with the spread of the efficient market hypothesis. Investors who accepted the efficient market hypothesis could not expect their fund managers to beat the market. Thus to increase their return, they could only concentrate on reducing costs. Index-tracking-ETFs were the financial industries' response to the needs of this group of investors.

This unofficial division which saw most passively managed funds in the form of ETFs and most actively managed funds in the form of mutual funds did not last for long. With the proliferation of funds over the past decade, currently, many mutual funds follow various indexes, and many ETF managers actively try to outperform the relevant market index. For examples of active and passive ETFs, you can see the best Canadian ETFs page, while for examples of active and passive mutual funds, you can see the best Canadian mutual funds page.

As a result, ETFs and mutual funds are currently in direct competition for assets to manage. The pie chart above shows how small ETF assets are compared to mutual fund assets in Canada. But this figure does not show the complete picture. To better understand this competition, consider the second pie chart, which is similar to the first one except for its date.

While at present, ETFs constitute only 14% of all Canadian funds (judging by assets under management), 2.5 years ago, they comprised 11% of funds. So it seems that mutual fund's upper hand is merely due to having a first movers advantage. ETFs are catching up.

It is pretty interesting to see that almost half of the mutual fund's assets are in balanced funds. Balanced funds invest in a mix of bonds and stocks to provide the best risk-reward ratio for their investors. This concentration of assets in balanced funds suggests that mutual fund investors are primarily looking for ready-made investment solutions.

In the case of ETFs, the lion's share of assets under management, 64%, go to equity funds. Likely, most of these equity ETFs follow major stock indices, as their investors hope that stock markets will deliver returns similar to what they have provided historically. ETF investors seem to be more DIY-type personalities who prefer to determine the mix of equity and bond in their portfolios.

Management expense ratio (MER) is the total fund's expenses divided by the fund's average assets under management (AUM). On average, MER is lower for ETFs than MER for mutual funds. For example, if you want exposure to the S&P 500 index, you can buy ZSP, BMO S&P 500 Index ETF, or invest in CIBC U.S. Index Fund A. The former has an MER of 0.09%, while the latter’s MER is 1.18%.

The trading expense ratio (TER) is another expense involved with funds. TER is the total trading expenses incurred by the fund during the year divided by the average AUM. TER is often negligible for index-tracking ETFs.

TER is lower for ETFs than for open-ended mutual funds because of the mechanism for creating and redeeming fund units. The company which manages an ETF does not have to engage when new investors want to buy into that ETF, or an investor wants to cash out their units. Those investors would trade with each other on the exchange where the ETF is listed.

If demand for ETF units is higher than their supply, units will trade above their NAV. Inversely if there are many sellers and few buyers for the ETF units, they will sell below their NAV. If the price of an ETF becomes far enough from the ETFs NAV, an authorized participant (AP) enters the picture. An AP is a broker-dealer who engages in the creation and redemption of ETF units.

When ETF units are trading higher than NAV, AP will buy a block of stocks in the same proportion as the ETF is holding. It would then engage in a transaction with the ETF manager to exchange these shares for the corresponding number of units of the ETF, which it would sell to investors. This mechanism makes an ETF as liquid as its underlying stocks.

When ETF units are trading lower than their NAV, the reverse occurs. AP buys a block of ETF shares and surrenders them to the fund manager, who would, in return, provide an equivalent amount of stocks underlying the ETF. Creation units and redemption units are typically 50,000 ETF shares large. This way, ETF units are created or redeemed without the ETF incurring any trading cost or realizing any capital gain.

AP benefits from the difference between unit prices and NAV. As Milton Friedman famously put it, there is no free lunch.

In exchange for lower fund expenses and not facing capital gains tax due to fund redemption, ETF investors risk buying units at a price higher than NAV or selling units at a price less than NAV. Compare this complex process with a mutual fund which issues new units at NAV or redeems old units at NAV. In effect, we can think of an ETF as a mutual fund which has outsourced its issuance and redemption. If you are cautious and avoid using market orders, we believe the small price risk you accept in buying ETFs is often well worth your savings in MER.

You can trade an ETF any time during the day at the price determined by supply and demand at that specific time. While selling (or buying) units of a mutual fund, you can order the sale (or purchase) of your mutual fund units at any time; those orders would need to wait for the determination of the fund's NAV after the close of the market. This has created the illusion that ETFs have higher liquidity than mutual funds.

As we all know, any trade might take time to close. In real estate, where transparency is limited, and contracts often involve several contingencies, it is common for an agreement of purchase and sale to take a month to close a home purchase. In other words, in a real estate transaction, from the day there is an agreement of purchase and sale in place, it often takes a month for the seller to receive money and the buyer to get legal title to the property (and receive keys to the property).

In the case of financial transactions, there is often a much higher level of transparency; thus, the trades are often firm (have no condition attached to them). So the time to settle or close is much shorter. In 2017, American and Canadian markets moved from a T+3 settlement cycle to a T+2 settlement cycle for equity and long-term debt. Later in the same year, the Canadian Securities Administrators amended the regulatory document for mutual funds (National Instrument 81-102 Investment Funds) to adopt a T+2 Settlement Cycle for Conventional Mutual Funds.

This means that whether you trade long-term debt, stocks, ETFs or mutual funds, your broker would exchange your money with traded securities two business days after the date you trade them. Thus, using the standard definition of liquidity as the ability to cash out, generally, there is no liquidity difference between a mutual fund and an ETF. The possible exception is when no broker is in the middle, and you are trading directly with the fund issuer. In this case, your mutual fund might settle one business day after trading.

The only sense in which ETFs are more liquid is day trading. After selling ETF units, your broker knows you will receive the proceeds. Thus you can buy other financial instruments immediately as money from the ETF sale in two days would be used to settle your new purchase.

After a long time, savings accounts and GICs are once again able to produce some interest. But on further consideration, we notice that given the current level of inflation, real interest rates are still profoundly negative. So financial repression has not ended while the era of free money inflating all assets has ended. As a result, investment has become far more complicated than last decades.

Investment funds are powerful tools at investors' disposal. What is most important in determining the future returns of an investment fund is the assets it is invested in and the strategy it uses in its investment. When you feel two funds can’t be distinguished based on their assets and strategy, you would be better off paying less fees.

ETFs, on average, impose smaller fees on investors than mutual funds. Looking at the flow of money to mutual funds and ETFs during the first half of this year suggests that investors have noted this cost difference. While all ETF categories have been attracting money, the picture for mutual funds is mixed, and they were bleeding money on the whole.

It is instructive to look at the money flow to each mutual fund group. Investors have been escaping from bond funds and, to a lesser extent, from balanced funds while moving into equity funds. It seems that investors (with their advisors' help) were trying to protect themselves from rising rates by cutting their exposure to bonds. They seem to have forgotten that stock values are based on discounted future cash flows, and thus stock prices depend on interest rates just as bond prices.