ETFs and Other Mutual Funds

Million Dollar Journey today asks Can You Invest Solely in ETFs? The answer given is, basically, yes. And that is true. You could also live for a week eating only pickles. At least I’m pretty sure.

This is probably as good a time as any to give a quick rundown of the differences between open-end mutual funds and ETFs.

What is usually meant when somebody says “mutual fund” is an open-end mutual fund. Like with all funds, what you own when you own shares in an open-end fund is a proportionate share of a large portfolio of assets run by a management company.

With an open-end fund, you can buy or sell shares only once a day, at a price calculated based on the closing prices of everything in the portfolio. When you buy/sell shares, you are trading with the fund itself. If you buy, your money goes in the fund and new shares are issued to you. If you sell, your shares are cancelled and cash comes out of the fund.

Most open-end funds are “active” meaning that the management company is actively deciding on a day to day basis what to have in the portfolio. A sizable minority are “passive” or “index” funds that simply hold the members of a published index, such as the S&P 500.

ETFs, or Exchange Traded Funds, are similar in that you own shares of a portfolio, but these trade all day long on the stock exchange like a stock. When you buy or sell shares of ETFs, you are trading with another investor who is selling or buying.

For reasons I will spare you, ETFs are always passively managed portfolios.

In both types of fund the management company that runs it gets paid in the form of annual fees, sometimes referred to as “expenses.” (I’m not sure if an “expense” sounds smaller than a “fee”, but it sure does sound more unavoidable.) How much the management company charges varies a lot from fund to fund, but as a general rule, active open-end funds charge the most, followed by ETFs, followed by passive open-ended funds. Additionally, to buy or sell an ETF you would pay a commission to a stock broker.

So if ETFs are, essentially, index funds with higher fees than otherwise identical open-end index funds, why would you invest in them? The short answer is that most people reading this shouldn’t. The long one is that there are a few situations in which it makes sense. Since ETFs trade like stocks you can short them, buy them on margin, and trade them at a moment’s notice. There are also some rather exotic types of assets available as ETFs but not as open-ended funds. But if you are a typical investor looking to hold a vanilla index for more than a week or two, ETFs will only cost you more money.

Investing | Frank Curmudgeon | February 5, 2009 11:56 am

5 Comments

By kitty, February 7, 2009 @ 9:27 am

A question. When you say “So if ETFs are, essentially, index funds with higher fees than otherwise identical open-end index funds, why would you invest in them? The short answer is that most people reading this shouldn’t.” aren’t you forgetting the tax advantages of ETFs?
If I own a mutual fund, I have to pay taxes on capital gains distributions every year regardless on whether my holdings value increased or decreased. Also, not knowing the amount of these distributions is going to be and whether they are short-term or long-term, makes it more difficult to plan for taxes. You can be hit by AMT or you can end up with insufficient withholdings because of it.

With ETFs I only need to pay capital gains when or if I actually sell with gain.

I certainly know a lot less about investing than you do, so if I misunderstand something I’d appreciate it if you correct me.
By Frank Curmudgeon, February 8, 2009 @ 8:27 am

Kitty,

Amongst the advantages of index funds (ETF and otherwise) are that they rarely distribute much in the way of capital gains. This is because those distributions are caused by the fund buying and selling stocks, and index funds only need to trade when the index changes or when the fund has to raise cash or invest because of customer flows. For example, as I read their website, the Vanguard 500 fund hasn't made a capital gains distribution in at least two years.

Of course, most open-end mutual funds are actively managed, meaning that they buy and sell stocks constantly and can run up quite a capital gain to be distributed to the customers. As you say, this can be a serious tax planning challenge.

Thanks for the comment & hope this helps.
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