From the desk of Peter Blatt
April 24, 2013
When I lived in New Jersey we had a telephone that required a connection to an operator before one could make a long-distance call. A generation later, I have a smart phone, an iPhone in fact, that can dial a phone number in any area code by voice command (and that’s one of its most basic features!) Wow.
It’s fairly obvious that life is more connected, and therefore easier, with a cell phone, and more enjoyable with a smart phone. However, anytime you are trying to learn a new skill (how to use Skype to speak to family half-way across the world, for example) it typically holds true that change is hard. That’s a principle that’s also present in investment management.
One of the questions I get all the time from my clients at is how mutual funds and exchange-traded funds, or “ETFs” for short, differ. Much like how rapid advancements in micro-chip and processing technologies lead to a boom in demand for smarter, more efficient devices like the iPhone, demands for smarter, more efficient investment vehicles regularly come to market.
Such is the case with mutual funds and their close, but different cousins, the ETF.
Before I get into it, here’s a quick primer: both ETFs and mutual funds are baskets of securities (stocks, bonds, or both, depending on the fund). Because they offer multiple securities in one fell swoop, they’re well known for their diversification benefits and efficiencies of scale.
Here’s the three main ways ETFs differ from mutual funds
How they trade. ETFs are listed on stock exchanges and trade throughout the day, just like shares of Apple, Exxon, AT&T or any other stock. Mutual funds, on the other hand, are accessible only from the companies that manage the fund, and are usually traded only once daily at the close of the trading session – and at a price that is determined by the market.
This access matters because investors want the flexibility of being able to get in and out of the market quickly (think circa-September of 2008). Many long-term investors who aren’t trading their portfolios daily still like ETFs because they can get in and out of the trade easily if and when they want to.
The tax implications. ETFs are generally more tax-efficient than mutual funds. Why? Here’s a simple explanation: on the exchange, ETF buyers and sellers meet and trade dollars for shares and vice versa. Just like with any stock, when you sell your ETF, you’re subject to capital gains taxes if your shares appreciated in value since the acquisition date.
If you sell your traditional mutual fund at a gain, you’re subject to the same tax dynamics. But when you go to the mutual fund company to exchange your shares for dollars, the fund may need to actually sell fund assets and securities to generate the cash required to meet your redemption. If the fund has to sell these securities at a gain, it may recognize capital gains of its own.
Those capital gains are passed down to fund shareholders, whether you sold your shares or not.
The overall cost. Both ETFs and mutual funds charge an expense ratio, which covers the cost of managing the fund. Expense ratios can vary, but a general rule of thumb is that ETFs and index-based mutual funds tend to be less expensive than actively managed mutual funds.
This is because index fund managers try to create a portfolio that looks and performs as close to an index as possible, while active fund managers “actively” try to outperform. The higher expense ratio reflects that you’re paying someone to actively buy and sell securities on your behalf.
A great example is the PIMPCO Bond mutual fund with an expense ratio of 1.5%, and its sister ETF with an expense ratio of 0.5%. The comparison is in the chart above - the 1 year return on BOND is about 8% compared with the 1-year return of just under 2% for the mutual fund. The cost saving alone justifies the switch (they both have the same manager!) never mind the outsized performance.
Because ETFs trade on an exchange, you may incur transaction costs (a commission, for example) paid to the broker for executing your order. On the other hand, mutual funds may charge sales loads or redemption fees. Don’t believe your fund’s prospectus for a full list of potential charges. This article from the Wall Street Journal explains why.
So the question is which one is right for you: the wisdom and reliability of a flagship product, or the efficiency and flexibility of improved and streamlined technology. In other words, are mutual funds or ETFs more your speed?
If you would like a free review of your current portfolio, please schedule an appointment with me by calling Lauren at (561) 625-0900 x6. Remember, you can’t get a second opinion from the person who gave you the first. I would be happy to offer a free analysis on the true cost of your mutual fund portfolio or broker account if you would like – no strings attached, just call.
Until next time,