Mutual funds vs Exchange Traded Funds for retail investors

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The rise of ETFs has coincided with another important trend in the fund management industry, which is the rise of passively managed funds that invest in an index portfolio
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At year-end 2023, US financial services companies offered 8,582 mutual funds and 3,304 exchange-traded funds accounting for total net assets of USD 25 trillion and USD 8 trillion, respectively. More than 90 percent of total net assets of long-term mutual funds (including equity, bond, and hybrid funds) are owned by retail investors, but these funds have experienced huge outflows in the last 10 years, mainly driven by outflows from equity funds. At the same time, ETFs have experienced huge inflows from retail investors.

There are three main advantages of ETFs over mutual funds for retail investors – better liquidity, lower cost, and tax efficiency. Liquidity is perhaps the most attractive feature of ETFs for retail investors. ETFs can be traded any time during trading hours at market-determined prices. ETFs can be traded like stocks – you can buy ETF shares and you can short sell ETF shares. You can also buy or sell call and put options on ETFs. In contrast, the buy or sell orders for mutual funds are executed at the end of the day at their end-of-day NAV. You cannot take short position in mutual funds and there are no call-and-put options available on mutual funds. Also, unlike mutual funds, most ETFs have no requirement for minimum initial investment.

Lower cost is another attractive feature of ETFs. The expense ratios of mutual funds have been decreasing over time, but they remain higher compared to those for ETFs. Actively managed mutual funds may charge a front-end load when you buy their shares and a back-end load when you sell the shares. They also charge an annual expense ratio as a percentage of the total net assets. The expense ratio includes management fee, marketing or distribution fee, and other expenses. ETFs do not charge any load fees and their expense ratios are lower than those of mutual funds. The good news for investors is that the total fees charged by mutual funds have been decreasing over the past few decades, and the total fees for passively managed mutual funds, or index funds, are now very low.

The difference in fees between mutual funds and ETFs is not significant in the case of index funds. For example, Vanguard offers S&P 500 index benchmarked mutual fund and its equivalent ETF with expense ratios of 0.04% and 0.03%, respectively. However, when it comes to actively managed funds, the differences in fees between similarly structured mutual funds and ETFs can be significant.

The rise of ETFs has coincided with another important trend in the fund management industry, which is the rise of passively managed funds that invest in an index portfolio. Within the mutual fund industry, investors are now showing a strong preference for passively managed funds over actively managed funds. Research has shown that actively managed mutual funds do not outperform their benchmarks after deducting fees. Moreover, there is no evidence of persistence in the performance of mutual funds. That is, there is no guarantee that the funds that have given stellar returns this year will provide good returns next year. This underperformance, coupled with lower fees of index funds, has led investors towards investing in index funds. Since most of the ETFs are index funds, a shift in investors’ preferences from actively managed funds to passively managed funds is also reflected in their preference for ETFs in place of mutual funds.

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The third potential advantage for investors of ETFs is their tax efficiency. ETFs are generally more tax efficient than mutual funds. This is especially true in case of equity funds. Capital gains taxes on individual securities sold by a mutual fund manager are passed on to investors. A mutual fund investor must bear these capital gains taxes even if they are making losses on their mutual fund investment. In contrast, an ETF manager creates or redeems “creation units” in response to inflows or outflows from the fund. This means that investors do not have to bear capital gains taxes on individual securities which results in an overall lower tax burden. Mutual fund managers can use other tax saving strategies like carrying tax losses from previous years to minimize the total tax bill. Still, it is generally true that ETFs are better investments when it comes to tax management.

ETFs also score a little higher in terms of transparency. An investor can observe the price of ETF throughout the day. Moreover, most of the ETFs declare their portfolio holdings every day whereas mutual funds do so only once every quarter. Some investors may like higher transparency of ETFs although it does not necessarily lead to better returns.

Mutual funds are offered by fund families, like BlackRock, Fidelity, Vanguard, etc. These fund families are also the biggest ETF providers, and they often provide ETF versions of their popular mutual funds. Therefore, retail investors are going to have the luxury of choosing between a mutual fund and the ETF version of the fund. It is obvious that an investor who has a brokerage account to trade shares will prefer to buy ETFs instead of mutual funds due to their ease of trading, liquidity, lower fees, and tax efficiency. In all likelihood, ETFs will continue to grow at the expense of mutual funds in the future.

Vijay Yadav, Associate Professor of Finance, ESSEC Business School Asia Pacific