Mutual Funds vs ETFs: What’s The Difference?

For decades, mutual funds have been the primary investment vehicle for investors to achieve their investment goals. However, recent statistics highlight how rapidly things are changing with the emergence and growth of Exchange-Traded Funds (ETFs).

Globally, ETFs have increased from $204 billion USD in 2003 to over $9.6 trillion USD as of 2022. In this post, we’ll explain how an Exchange-Traded Fund differs from a mutual fund and outline the key reasons why investors have been adopting this investment vehicle at such a rapid pace.

Understanding ETFs

An Exchange-Traded Fund (ETF) is an investment fund that trades on stock exchanges, holding assets such as stocks, bonds, and other investments. ETFs are like mutual funds except they trade throughout the day and are generally more tax-efficient, transparent, and accessible.

Due to the efficiency of their structure, they are also often cheaper than their mutual fund counterparts.

Lower Fees and Their Impact

If you’ve heard of ETFs, you’ve probably heard it immediately associated with lower fees. This is because ETFs are typically passive investments, designed to replicate an index (like the S&P 500).

Conversely, mutual funds often employ “active managers” with the goal of beating their benchmark. A mutual fund might charge a 1% fee to try and outperform the market. However, data from the SPIVA Scoreboard shows that over a 15-year period, only ~7.8% of US-Listed Actively Managed Mutual Funds actually outperformed their benchmark.

This difficulty in beating the market, combined with higher fees, has shifted the conversation toward utilizing passive Index-replicating ETFs.

Illustrating Tax Efficiency

Perhaps more attractive than low fees are the tax efficiencies of ETFs. A study by Morningstar unveiled that the average equity mutual fund lost 1.48% of their returns to taxes from 2010-2020. This concept is known as “tax drag”.

• Mutual Funds: Incur taxable capital gains when managers sell securities to meet redemptions, passing the tax burden to investors annually—even if the investor didn't sell their own units.
• ETFs: Use an in-kind creation/redemption process, minimizing capital gains distributions.

For example, in 2022, when major US Equity indices were down 17-18%, 49% of mutual funds still distributed capital gains. This means many mutual fund investors saw their portfolios shrink in value, yet still owed taxes.

Conclusion: ETFs can carry big advantages over Mutual Funds that result in net fee and tax savings to the investor.