Six elements of the difference between two kinds of investment company.
In 28 years the U.S. exchange-traded fund industry has gone from nothing to $5.5 trillion in 2,200 funds. These funds have important differences from mutual funds, which have been around for a century. How do ETFs work? When are they the better option for an investor?
#1 ETFs are pools.
If you had $10,000 to invest and wanted it spread among 500 different companies, you could put in 500 buy orders, most of them for fractional shares. Very impractical. Or, you could place one $10,000 order for a fund that pools money from many investors and uses it o buy large positions in all 500 stocks.
In this respect, ETFs have the same structure as mutual funds.
#2 ETFs trade like stocks.
Just like shares of Microsoft or Tesla, ETF shares trade all day long on the stock exchange and have bid and ask prices. If an ETF is quoted at $50 bid, $50.10 ask, a market maker stands ready to sell you the shares you want at $50.10 or take shares off your hands at a price of $50. You get in and out of the fund, that is, by trading with the middleman.
What Are Mutual Funds? A Guide For New Investors
The older mutual fund system works in an entirely different way. The buys and sells of fund shares take place once a day and are handled by the operator of the fund. If a no-load fund’s portfolio is worth $50.05 per fund share at the end of the trading day, all the buys and sells take place at that price.
#3 ETFs use a specialized breed of intermediary.
Not all market makers in the shares of an ETF are the same. Some, called “authorized participants,” do more than just quote bid and ask prices. They are able to create and extinguish fund shares. These intermediaries are the foundation to liquidity in the fund.
If more investors want into the fund than want out, the price will be pushed above the portfolio value of a share. At that point an authorized participant buys a basket of stocks matching the fund’s portfolio, and trades that basket in for a block of newly issued ETF shares. For an ETF tracking the S&P 500 index, the trade might involve 50,000 shares of the fund worth $10 million. The middleman might have to acquire $500,000 worth of Apple shares, $350,000 of Amazon and 498 other positions. The newly created fund shares replenish the middleman’s inventory.
If more investors want out than in, the process works in reverse. The authorized participant buys unwanted ETF shares for cash. It hands in a big block of ETF shares, gets in return stock in Apple, Amazon and the rest, and then sells those positions. Proceeds from the 500 sell transactions repay the middleman for cash laid out in acquiring the unwanted shares.
This roundabout way of getting money in and out of a fund in response to popular demand serves a very important purpose. In an old-style mutual fund, the fund incurs trading costs when a flood of new money comes in or there’s a big exodus. Those costs are borne by all investors in the fund, including the ones who buy and hold. With an ETF, the cost of trading is pushed onto the shoulders of investors who come and go.
#4 ETFs have a tax advantage.
When a mutual fund sells a position at a profit, it is obliged to distribute the resulting gain to its investors, who then have to pay tax on the gain. ETFs can largely skirt this problem. That’s for two reasons.
One is that an ETF rarely has to sell positions for cash; instead, it’s mostly just swapping stock in Amazon and Apple and so on for fund shares. The other is that for this swap the ETF can select its lowest-cost lots of Amazon and Apple. With this maneuver, the fund is left with high-cost shares on its books. If it does do any selling for cash, for example to realign the portfolio, it will probably end up with few gains, or even a net capital loss at the end of the year. Capital gain distributions are uncommon in ETFs.
This distinction between ETFs and mutual funds is not set in concrete. Congress could remove it by forcing ETFs to distribute taxable gains, or by telling mutual funds they don’t have to distribute gains. Meanwhile, there’s no difference in the treatment of dividend and interest income. Both kinds of funds have to distribute that.
#5 Most ETFs are index funds.
An index fund may track a broad-based index like the S&P 500, or a narrower one, such as one for clean energy stocks. Either way, it will have a fairly stable portfolio that requires little involvement by a portfolio manager. Because they require less work, passive index funds tend to have low fees.
Some ETFs are actively managed. These account for only a sliver of the industry’s assets, but they are becoming more common.
The preponderance of index funds in the ETF business explains why ETF management fees are, on average, lower than mutual fund fees. But there are plenty of exceptions to the pattern: expensive ETFs and cheap mutual funds.
#6 Investors should be choosy.
Which is better for you, an exchange-traded fund or a mutual fund with a very similar portfolio? That depends.
If you’re interested in stocks, and buying in a taxable brokerage account, you will probably be better off with an ETF than with a similar mutual fund. Taxes on price appreciation will be deferred until you sell the ETF.
If you’re buying in an IRA or 401(k) you can be indifferent to the capital gain distributions. The tax distinction between ETFs and mutual funds is also unimportant in bond funds, since bonds don’t appreciate much.
Long-term holders are likely to be better off in ETFs for a different reason. They incur a round-trip trading cost (commission and bid-ask spread) only once, and are spared the damage caused by other investors going in and out.
Mutual funds tend to be the better choice for savers making small, regular contributions to a retirement account. They usually are available in retirement plans without a sales load, while ETF purchases are likely to involve bid/ask spreads and commissions.