This blog post is adapted from my French column with the newspaper Les Affaires.
Mutual funds and exchange traded funds – or ETFs – are almost identical investment vehicles that allow you to acquire shares in an investment portfolio. The difference between them is that investors trade mutual funds directly with a fund company, while ETFs are traded on an exchange like stocks.
Over the past few years, the emergence of ETFs has shaken the world of financial services by causing fierce competition for mutual funds. In the United States, ETFs hold an astonishing share of the market, while in Canada they have experienced more moderate growth. Mutual funds, however, still have important advantages when compared with ETFs.
Form and contents
Before looking at the benefits of mutual funds and ETFs, we must first consider what makes all investment products different: their form and contents. Both mutual funds and ETFs are primarily investment vehicles (i.e., the form), but their contents are the number one criteria that determine the quality of each of these individual products. The quality of an ETF or a mutual fund depends above all on the quality of the portfolio held and the chosen investment approach. If the quality of the contents is poor, it is hard to achieve a good performance.
It is also important that you inquire about the management fees deducted by the fund since you are the one paying them! Every dollar paid to the mutual fund or ETF company is a dollar less in your pocket. Think about this carefully.
Mutual funds are easy to purchase. Unlike ETFs, you simply fill out the required forms with a bank, a mutual fund dealer or a securities dealer, and you’re done. Investing in mutual funds is risk free when it comes to executing buy and sell transactions. The transactions are settled based on the fund’s net asset value, which is calculated using the portfolio security closing prices. Consequently, you do not have to execute transactions yourself on an exchange to invest in mutual funds because you deal directly with the mutual fund company. ETFs, however, are traded on an exchange, as indicated by their name. They require you to open an account with a securities dealer and place orders on the market (yourself or with the help of an investment advisor), which involves risk. If you place an order incorrectly, the transaction may be executed at a less favorable price than expected.
In addition, if you prefer active to passive portfolio management, mutual funds will provide you with the greatest product variety. The mutual fund market also offers a few passively managed funds with reasonable management fees.
Mutual funds also allow you to make regular contributions or withdrawals to and from your portfolio. This can be particularly useful for young investors looking to establish good savings habits and retirees needing efficient tools to structure their retirement income.
Unlike mutual funds, ETFs include an extraordinary variety of top-quality passively managed funds and offer the lowest management fees available. If, like me, you believe in passive management for its numerous benefits, you will agree that ETFs are almost like having your cake and eating it too: they offer a better, lower-cost investment approach.
The other, often forgotten, benefit of ETFs is their predictability. As most of them (about 75% of the market) are passive funds, known as index funds, they practically mirror their benchmark index. So what? Let’s say that you invested in a quality ETF based on the Canadian S&P/TSX Composite Index. At the end of the year, the return on your investment will probably be lower than the return on the index by a tiny fraction of a percentage point, considering the low management fees that you pay. This means that you avoid the risk of obtaining a return that is much lower than the Canadian stock market as a whole. On average, you will obtain about the same return as the benchmark index, which, in the end, is a result that few investors are able to achieve.
The most common ETFs are most often offered in a single category, and extremely complete information is available on each of them. By comparison, mutual funds are offered in such a wide variety of categories (A, B, C, D, E, F… almost the entire alphabet) that investors can hardly make head or tail of them. All of the categories offer the same portfolio but with different forms of advisor compensation and, therefore, different management fees (what you pay). For transparency purposes, I suggest that you visit the websites of the biggest ETF providers (iShares, BMO ETFs and Vanguard are the biggest in Canada) and compare the information on them with the websites of the biggest mutual fund providers. Let me know what you find out!
Investor Action Plan
Before investing in mutual funds or ETFs, you should:
- Verify the quality of the portfolio and the investment strategy;
- Find out about the management expense ratio (as a percent) so that you know what you are committing to pay.
You should choose mutual funds if:
- You do not want to place orders on an exchange;
- You prefer actively managed funds;
- You want to make systematic contributions or withdrawals to and from your portfolio.
You should choose ETFs if:
- You prefer passively managed funds and you want to pay low management fees;
- You want predictable results that practically mirror the returns (positive or negative) of the market indices;
- You like having complete information and you are too old for alphabet soup!