What Is an ETF & Why Have They Surpassed Mutual Funds in Popularity?

There is a sea change happening in the investment industry where the inflows into ETF’s are rapidly outpacing the inflows into mutual funds.  See the chart below, showing the total asset investments in ETFs vs Mutual Funds going back to 2000, as well as the Investment Company Institute’s projected trends going out to 2030.   

Why is this happening?  While mutual funds and ETFs may look similar on the surface, there are several dramatic differences that are driving this new trend.

What is an ETF?

ETF stands for Exchange Traded Fund.  On the surface, an ETF looks very similar to an index mutual fund.   It’s a basket of securities often used to track an index or an investment theme.  For example, Vanguard has the Vanguard S&P 500 Index EFT (Ticker: VOO), but they also have the Vanguard S&P 500 Index Fund (Ticker: VFIAX); both aim to track the performance of the S&P 500 Index, but there are a few differences. 

ETFs Trade Intraday

Unlike a mutual fund that only trades at 4pm each day, an ETF can be traded like a stock intraday, so if you want to see $10,000 of the Vanguard S&P 500 ETF at 10am, you can do that, versus if you are invested in the Vanguard S&P 500 Index Fund, it will only trade at 4pm which may be at a better or worse price depending where the S&P 500 index finished the trading day compared to the price at 10am. 

How ETFs Are Traded

When it comes to comparing ETFs to Mutual Funds, a big difference is not only WHEN they trade, but also HOW they trade.  When you sell a mutual fund, your shares are sold back to the mutual fund company at 4pm and settled in cash.  An exchange traded fund trades like a stock where shares are “exchanged” between a buyer and a seller in the open market, which is where ETF’s get their name from. They are “exchanged”, not redeemed like mutual fund shares. 

ETF Tax Advantage Over Mutual Funds

One of the biggest advantages of ETFs over mutual funds is their tax efficiency, which relates back to what we just covered about how ETFs are traded.  When you redeem mutual fund shares, if the fund company does not have enough in its cash reserve within the mutual fund itself, it has to go on the open market and sell securities to raise cash to meet the redemptions. Like any other type of investment account, if the security that they sell has an unrealized gain, selling the security to raise cash creates a taxable realized gain, and then the mutual fund distributes those gains to the existing shareholders, typically at the end of the calendar year as “capital gains distributions” which are then taxed to the current holders of the mutual funds.

If the current shareholders are holding that mutual fund in a taxable account when the capital gains distribution is issued, the shareholder needs to report that capital gains distribution as taxable income. This never seemed fair because that shareholder didn't redeem any shares, however since the mutual fund had to redeem securities to meet redemptions, the shareholders that remain unfortunately bear the tax burden.

Example:  Jim and Sarah both own ABC Growth Fund in their brokerage accounts.  ABC has performed well for the past few years, so Sarah decides to sell her shares. The mutual fund company then has to sell shares of stock within its portfolio to meet the redemption request, generating a taxable gain within the mutual fund portfolio. At the end of the year, ABC Growth Fund issues a capital gain distribution to Jim, which he must pay tax on, even though Jim did not sell his shares, Sarah did.

ETFs do not trigger capital gains distributions to shareholders because the shares are exchanged between a buyer and a seller, an ETF company does not have to redeem securities within its portfolio to meet redemptions.  So, you could technically have an ABC Growth Mutual Fund and an ABC Growth ETF, same holdings, but the investor that owns the mutual fund could be getting hit with taxed on capital gains distribution each year while the holder of the ETF has no tax impact until they sell their shares.

Holding ETFs In A Taxable Account vs Retirement Account

Tax efficiency matters the most in taxable accounts, like brokerage accounts. If you are holding an ETF or mutual fund within an IRA or 401(k) account, since retirement accounts by nature are tax deferred, the capital gains distributions being issued by the mutual fund companies do not have an immediate tax impact on the shareholders because of the tax deferred nature of retirement accounts.   For this reason, there has been less urgency to transition from mutual funds to ETFs in retirement accounts.  

Many ETFs Don’t Trade In Fractional Shares

The second reason why ETFs have been slower to be adopted into employer sponsored retirement plans, like 401(k) plans, is most ETFs, like stocks, only trade in whole shares. Example:  If you want to buy 1 share of Google, and Google is trading for $163 per share, you have to have $163 in cash to buy one whole share. You can’t buy $53 of Google because it’s not enough to purchase a whole share.  Most ETF’s work the same way. They have a share price like a stock, and you have to purchase them in whole shares. Mutual funds by comparison trade in fractional shares, meaning while the “share price” or “NAV” of a mutual fund may be $80, you can buy $25.30 of that mutual fund because they can be bought and sold in fractional shares.

This is why from an operational standpoint, mutual funds can work better in 401(k) accounts because you have employees making all different levels of contributions each pay period to their 401(K) accounts - Jim is contributing $250 per pay period, Sharon $423 per pay period, Scott $30 per pay period. Since mutual funds can trade in fractional shares, the full amount of those contributions can be invested each pay period, whereas if it was a menu of ETFs that only traded in full shares, there would most likely be uninvested cash left over each pay period because only whole shares can be purchased.

ETF’s Do Not Have Minimum Initial Investments

Another advantage that ETF’s have over mutual funds is they do not have “minimum initial investments” like many mutual funds do. For example, if you look up the Vanguard S&P 500 Index Mutual Fund (Ticker VFIAX), there is a minimum initial investment of $3,000, meaning you must have at least $3,000 to buy a position in that mutual fund.  Whereas the Vanguard S&P 500 Index ETF (Ticker: VOO) does not have a minimum initial investment, the current share price is $525.17, so you just need $525,17 to purchase 1 share.

NOTE: I’m not picking on Vanguard, they are in a lot of my example because we use Vanguard in our client portfolios, so we are very familiar with how their mutual funds and ETFs operate. 

ETFs Do Not CLOSE To New Investors

Every now and then a mutual fund will declare either a “soft close” or “hard close”.  A soft close means the mutual fund is closed to “new investors” meaning if you currently have a position in the mutual fund, you are allowed to continue to make deposits, but if you don’t already own the mutual fund, you can no longer buy it.   A “hard close” is when both current and new investors are no longer allowed to purchase shares of the mutual fund, existing shareholders are only allowed to sell their holdings.

Mutual Funds will sometimes do this to protect performance or their investment strategy. If you are managing a Small Cap Value Mutual Fund and you receive buy orders for $100 billion, it may be difficult, if not impossible to buy enough of the publicly traded small cap stock to put that cash to work. Then, the fund manager might have to expand the stock holding to “B team” selections, or begin buying mid-cap stock which creates style drift out of the core small cap value strategy.  To prevent this, the mutual fund will announce either a soft or hard close to prevent these big drifts from happening.

Arguably a good thing, but if you love the fund, and they tell you that you can’t put any more money into it, it can be a headache for current shareholders.

Since ETFs trade in the open market between buyers and sellers, they cannot implement hard or soft closes, it just becomes, ‘how much are the current holders of the ETF willing to sell their shares for in the open market to the buyers’.

ETFs Can Offer A Wider Selection of Investment Strategies

With ETFs, there are also a wider variety of investment strategies to choose from and the number of ETFs available in the open market are growing rapidly.   

For example, if you want to replicate the performance of Brazil’s stock market within your portfolio, iShares has an ETF called MSCI Brazil (Ticker: EWZ) which seeks to track the investment results of an index composed of Brazilian equities.   While traditional indexes exist within the ETF world like tracking the total bond market or S&P 500 Index, EFTs can provide access to more limited scope investment strategies.

ETF Liquidity Risk

But this brings me to one of the risks that shareholders need to be aware of when buying thinly traded ETFs.  Since they are exchange traded funds, if you want to sell your position, you need a buyer that wants to buy your shares, otherwise there is no way to sell your position. One of the metrics we advise individuals to look at before buying an ETF is the daily trade volume of that security to determine how easily or difficult it would be to find a buyer for your shares if you wanted to sell them.

For example, VOO, the Vanguard S&P 500 Index ETF has an average trading volume right now about 5 million shares and as the current share price is about $2.6 Billion in activity each day, there is a high probability that if you wanted to sell $500,000 of your VOO, that order could be easily filled.  If instead, you are holding a very thinly traded ETF that only has an average trading volume of 100,000 share per day and you are holding 300,000 shares, it may take you a few days or weeks to sell your position and your activity could negatively impact the price as you try to sell because it could move the market with your trade given the light trading volume. Or worse, there is no one interested in buying your shares, so you are stuck with them.  You just have to do your homework when investing the more thinly traded ETFs.

Passive & Active ETFs

Similar to mutual funds, there are both passive and active ETF’s. Passive ETFs aim to replicate the performance of an existing index like the S&P 500 Index or a bond index, while active strategy ETFs are trying to outperform a specific index through the implementation of their investment strategy within the ETF. 

About Michael……...

Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.