ETFs vs. Mutual Funds: A Quick Primer

by Leslie N. Masonson, MBA

Mutual funds have been around for over 100 years, while the first ETF was born only 30 years ago. Most of the former were set-up as active funds (requiring active portfolio management) with accompanying high expenses, but eventually no-load passively managed index funds were offered, as investors balked at paying those annual fees, eating into their returns.

Most Investors growing up in the 1950s through the early 1990s were aware that mutual funds were the only way to invest in a basket of securities instead of buying them individually.  This four-decade period was the most prosperous for mutual fund companies and brokers who sold these products, maintaining a comfortable living from mutual fund fees (front-end and/or back-end loads, 12b-1 marketing fees (0.25% typical), trading fees, and transaction fees).

No-load mutual funds have become much more popular in the last 20 years, as investors balked at paying the 3% to 8% front-end loads on active mutual funds (actively managed by portfolio managers).  Passive mutual funds (fixed portfolios with limited or no management required) such as indexed funds have no loads and lower expense ratios than active mutual funds.

Let’s first review some numbers comparing mutual funds and ETFs, and then n 20 cover the more qualitative differences and similarities. Even with the ETF competitors, the number of mutual funds owning households from 1990 through 2022 has increased from 23.4 million to 68.6 million making them still the foremost player in the funds arena. Surprisingly though, since 2000, the number of equity mutual funds (domestic; not global) has declined from 3,308 to 1,930 in 2021, while the number of equity ETFs (broad-based and sector; not global) increased from 55 funds in 2000 to 1,273 in 2021, a 2,215% increase.

Clearly, ETFs have been where the action is happening. In 2022, mutual funds had net outflows of $1.1 trillion indicating the shifting sands with the funds leaving because of losses incurred by shareholders due to the market swoon and increased competition from ETFs and fixed-income vehicles to take advantage of rising short-term interest rates.

Remarkably, about 45% of all households continued to own mutual funds from 2000 through 2021, but that percentage jumped to 52% in 2022, a welcome sign for the fund companies. While only 12% of households own ETFs, there is still a huge disparity between their acceptance.  Still, Baby Boomers and Generation X continue to own 75% of all mutual fund assets, compared to just 14% for the younger Generation Z and Millennials who prefer to use ETFs, if they want to buy indexes.

This minimal mutual fund growth is mostly due to the rapid acceleration of ETF acceptance in the past two decades resulting from institutional and retail investor interest. The five largest ETF sponsors have captured the majority of assets, and continue to increase market share each year.

ETFs have been on a tear. As of June 9, 2023, according to ETFAction.com, there are 3,130 ETFs available valued at $7.15 trillion.  This compares with $22.1 trillion in mutual funds (year-end 2022), still only one-third of mutual fund assets. One major reason ETFs have expanded is the wide number of investment choices — not just plain vanilla index funds.

The most important fee is the annual expense ratio which is the percent of assets used to pay the salaries of the fund managers. This fee has been declining steadily since 2000 with equity mutual funds having an expense ratio of 0.99% ($0.99 for every $100 invested) on an asset-weighted basis in 2000 dropping to 0.47% in 2021.  ETFs, on the other hand, have an average expense ratio of 0.16%.

As most experienced investors have learned, the difference in these expense ratios between similar funds over decades can amount to thousands, if not tens of thousands of dollars.  For example, taking the expense ratio from the last paragraph and applying it to an example of investing $100,000 for 20 years with an annual return of 10% would result in a closing balance difference of $35,912 with the 0.16% ratio fund having total fees of $19, 302 compared to $55,214 for the 047% fund. Clearly, this is a significant difference that one can ill afford to not pay attention to when purchasing any fund. Be aware that not all ETFs have lower expense ratios than their mutual fund equivalent.  Understand that, there are some index mutual funds that have very low expense ratios compared to their ETF equivalents, so investors need to do their homework to find them.

Now let’s cover the differences and similarities of these funds. Let’s first review their similarities:

•         Hold a basket of securities dependent on their fund’s objective
•         Are a popular investment choice for most investors
•         Both are open-ended, meaning they do not limit the number of shares sold
•         All securities held risk
•         Are easy to purchase online or via an app
•         Can be sold easily without any lock-up period
•         Their websites provide detailed fund information, and other sites rank and provide buy and sell recommendations
•         Available passive and active versions
•         Evaluation is possible using technical analysis with charting software, but not all sites include both mutual funds and ETFs in their universe, but there are many to choose from
•         Charge operating fee called an “expense ratio”
•         No-load mutual funds and ETFs have no commission

Now let’s cover their main differences:

•         The first mutual was launched in 1924 compared to the first ETF in January 1993.
•         The current number of ETFs is 3,130 valued at $7.15 trillion compared to 7,176 mutual funds valued at $22.1 trillion.
•         ETFs can be traded throughout the day like stocks.  Mutual funds cannot be traded during the day. Their closing NAV price at 4 PM each trading day is the only price available for a purchase or sale.
•         ETFs are traded on secondary markets (stock exchanges), while mutual funds must be purchased directly from the fund itself, through a brokerage firm offering that fund, a financial planner, or a financial advisor at a bank or savings institution.
•         The portfolio of each fund is available for viewing, but mutual funds are only required to update their holdings quarterly and have 60 days after the quarter to do so. ETF portfolios are updated daily unless the ETF is the non-transparent type which is few in number.

CONCLUSION

Of the two fund options, ETFs have become the overwhelming choice for younger investors, while more experienced investors are now selecting ETFs instead of comparable mutual funds for new purchases. The main reasons for the ETF surge in popularity are their simplicity, convenience, and their low expense ratio cost.

Moreover, other important characteristics include their intra-day trading accessibility, ease of making a trade either online or via a brokerage app, ability to place stop orders to limit losses and protect profits, superior tax efficiency, complete portfolio transparency, and ability to buy unusual or specific baskets of securities (e.g., theme-based, style, commodity, leveraged, inverse or buffered, hedging, among others) that are unavailable in the mutual fund format.

For the millions of younger investors, ETFs have the feel of a more modern way to conveniently invest with no commissions, where a diversified portfolio can be bought with a few keystrokes on an app or computer.  However, they may decide to invest directly in stocks which will slow down their participation in ETFs until they become more mature, and understand their need to save for retirement where index portfolios are the preferred vehicles.

VectorVest provides comprehensive ETF analysis with the “ETF Viewer” which ranks 1867 ETFs by VST and other critical metrics, while the UniSearch feature provides numerous ETF investing and trading strategies for investors with varying risk profiles.  These powerful tools will be featured in future articles.  Next up, though, are the many different types of ETFs in the marketplace, so stay tuned.

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