Actively managed ETFs vs mutual funds
Seven key differences you need to know
While exchange-traded funds (ETFs) and mutual funds share some characteristics, they also come with important differences that investors should be aware of.
What do they have in common?
Actively managed ETFs and mutual funds allow investors to diversify their portfolios and manage risk by providing exposure to a variety of securities, such as stocks and bonds. Both are managed by professional portfolio managers who align investment decisions with investment objectives and typically seek to meet certain risk or income parameters or provide returns above a passive benchmark.
Where do they differ?
- Tax efficiency
- Fees and expenses
- Income frequency
- Holdings transparency
- Trading flexibility
- Tactical flexibility
- Minimum investment
Tax efficiency: ETFs offer a favorable tax profile
ETFs: The mechanics of ETFs allow for tax efficiency through what is referred to as an in-kind redemption process. In this process, a large institutional investor, referred to as an authorized participant (AP), exchanges shares of the ETF for the underlying securities in the ETF. The AP gives ETF shares back to the ETF issuer, who then provides a basket of the underlying securities back to the AP. Since this is done in-kind, the process mitigates the need for the portfolio manager of the ETF to sell positions that have associated unrealized gains. This process results in fewer ETF capital gains distributions – enabling the ETF to grow without the performance drag of realized capital gains taxes. Simply stated, capital gains taxes can be deferred until the ETF investor decides to sell their ETF shares.
Mutual funds: On the other hand, mutual funds often distribute capital gains to investors at year-end, regardless of whether the investor sold any shares. For example, if a mutual fund manager sells stock at a profit within the fund, all shareholders may incur a pro-rata capital gains tax – even if they did not sell their mutual fund shares during the year. It is important to note that capital gains may be distributed even in years when the mutual fund has lost value.
Lower costs: Understanding fees and expenses
ETFs: ETFs typically don’t come with sales loads or added marketing and distribution fees such as 12b-1 fees and, therefore, tend to have less of a performance drag from costs than mutual funds. This lower all-in cost structure can have a positive impact on returns.
Mutual funds: In contrast, mutual funds can carry various fees, including 12b-1 fees and sales loads, which can be either front-end or back-end. For example, a mutual fund with a 5% front-end load reduces an investor’s initial investment by that percentage before any money is invested, immediately diminishing the growth potential.
Regular income: ETFs can provide monthly or quarterly distributions
ETFs: ETFs can distribute earnings generated by underlying holdings to investors, often in the form of dividends or income. Distributions can be scheduled as frequently as monthly or quarterly, which provides opportunities for reinvestment to compound growth or immediate cash flow. The cash flow option can be particularly attractive for income-focused investors as they can use it to supplement other forms of income.
Mutual funds: Mutual funds typically only distribute dividends annually or semi-annually, resulting in less frequent cash flow compared to ETFs. This lag in dividend distribution can impact an investor’s cash flow planning, particularly for those who look to rely on regular income from their investments.
Daily transparency: Making informed decisions
ETFs: ETFs typically disclose holdings daily, which provides investors with real-time insight into their investments. This transparency enables investors to monitor their exposure to stocks and bonds at a granular level, enabling better informed portfolio construction and risk management process overall.
Mutual funds: Mutual funds usually disclose holdings quarterly, with a lag, creating uncertainty about current investments. This lack of transparency can make portfolio construction and risk management less efficient and hinder an investor’s ability to make fully informed investment decisions in response to market shifts.
Trading flexibility: Real-time liquidity with ETFs
ETFs: ETFs trade on stock exchanges (like stocks, but not mutual funds), which allows investors to buy and sell shares at market prices throughout the day. This can be particularly desirable during periods of heightened market volatility. To control the price at which an investor is willing to trade an ETF, they can use what is called a ‘limit order’. Limit orders allow ETF investors to set the limit on the max price they are willing to pay for an ETF that they are buying, and the lower limit on the price of an ETF they are looking to sell. This is particularly important when trading smaller ETFs with lower volume. Please see “ETF Trading Best Practices” for more on this topic.
Mutual funds: Buy and sell orders are processed once daily when the market closes. The fund price is based on its net asset value (NAV), which is determined only once per day at market close.
Tactical flexibility: ETFs help navigate volatility
ETFs: ETF investors can implement trading strategies such as stop-limit orders, allowing them to manage risk and protect gains effectively. For example, if an investor in an equity ETF expects a market decline to continue, they can sell that ETF at a pre-determined price to avoid further losses.
Mutual funds: Mutual funds do not offer the same level of control during volatile periods, as they are subject to end-of-day pricing and would have to remain invested until the market closes.
Low minimum investment: Opens doors for everyone
ETFs: The minimum investment is the price of one ETF share. This low barrier to entry can be particularly beneficial for investors with smaller account sizes, allowing access to multiple investment strategies and putting rebalancing and dollar-cost averaging strategies within reach.
Mutual funds: Many mutual funds impose minimum investment requirements, which limits access for many investors. This can complicate asset allocation and portfolio diversification, particularly for clients just starting their investment journeys.