Mutual funds and exchange traded funds are types of professionally managed assets, but there are major differences. First, a mutual fund (or its proper name, “open end investment company”), is priced only at the end of the trading day, when its “net asset value” (NAV) is determined. The NAV of any mutual fund is computed by taking the portfolio’s total market value at the end of any trading day, then subtracting any fund liabilities, and, finally, dividing the resulting number by the number of outstanding shares in the fund. The fund is said to be “open ended” since it continually offers new shares to investors and remains ready to buy back outstanding shares from investors. Alternatively, an exchange traded fund (“ETF”), trades like a stock, meaning an immediate price is obtained when there is a trade of the share (or more properly, the “depository receipt”). While the ETF is also valued according to its NAV at the end of the closing day, the more relevant value is its “intraday NAV”, the difference between its NAV and market price. 

A second major difference is the type of assets in which a mutual fund invests as compared with the ETF. There are numerous categories of mutual funds depending on the fund’s investment objective, but generally these categories are listed as part of a fund that invests solely in stocks or bonds or a combination of stocks and bonds, referred to as a “balanced fund”. A notable separate type of mutual fund is an “index fund” or a fund that invests only in the shares of a major index such as the Standard & Poor index of 500 stocks (“S&P 500”). Alternatively, an ETF typically invests solely in index funds. Indeed, an ETF is often described as an “index fund that trades like a stock”. 

A final major difference is that most mutual funds (with the notable exception of the index fund) are managed “actively”. If the fund portfolio manager practices “active management” techniques, it means that the manager or investment company is attempting to outperform a broad market index, such as the S&P 500 Index of stocks, on a longer term or more-than-one-year performance basis. Alternatively, most ETF’s are managed “passively”. At the heart of “passive management theory” is a belief that any market or stock exchange is “reasonably efficient”, meaning that there is no immediately apparent way to outperform the broad market index. As a result, an ETF manager attempts only to match the market index and does not trade the portfolio’s holdings nearly as frequently as an “active manager”, thereby resulting in lower costs to the investor.

An investor’s annual total return, both in terms of dollars and percentage, from a professionally managed asset, such as a mutual fund or ETF, is heavily dependent on the fees charged to manage the portfolio. For example, if a fund imposes a management fee of one percent (1%) of its total NAV to manage the assets, an investor must achieve an annual return of at least one percentage more than the return the market index returns. Moreover, if the investment advisor charges a fee of an additional one percent to select the fund and manage the investor’s individual portfolio, the “bar” to overcome is now at least two percent (2%) more than the performance of the market index. Studies have shown that over a long period of time, for example 10 or 20 years, the recovery of these fees by the investor is extremely difficult to recoup. Thus, the greater the fees imposed by the fund or advisor, the more difficult it is to accumulate wealth over time. 

A major advantage of the ETF form of professionally managed assets is its fee structure, resulting in a relatively low amount of fees imposed on the investor. In part, this is because a fee is only incurred if the underlying assets in the ETF are traded (bought or sold). Since the ETF is managed “passively”, and trading of its underlying assets is relatively infrequent, a fee advantage over the mutual fund results. Still another way in which ETFs achieve a fee advantage is because of how the ETF trades. Specifically, as mentioned previously, an ETF trades its shares like a stock. Accordingly, the sale of an ETF share from one investor to another has no impact on the value of the overall fund. Conversely, when a mutual fund shareholder sells his or her shares, they must be “redeemed” (bought back in cash) from the investor. Sometimes, this requires the mutual fund to sell shares to raise cash to cover the cost of the redemption. As a result, the operating expenses of the mutual fund are typically more as compared to the ETF.

For an individual interested in investing in a professionally managed asset, the question arises: “Which is best, the mutual fund or the ETF”? A related question is: In which category of mutual fund or ETF, such as stocks or bonds, should an individual invest? However, before answering these questions, an individual should understand that both mutual funds and ETFs provide a major advantage over individual stocks and bonds: that of, instant diversification. Diversification is the art of constructing a portfolio to exhibit less total risk without experiencing an equal reduction in expected return. The construction of a fully diversified portfolio is the major benefit that a portfolio manager and investment advisor “brings to the table” and how the advisor in part “earns his fee”! 

The key to properly diversifying a portfolio is to diversify “across and within” sectors of the market. There are 11 sectors of the market as follows:

• Technology
• Financials
• Utilities
• Consumer Discretionary
• Consumer Staples
• Energy 
• Healthcare
• Industrials
• Telecom
• Materials
• Real Estate

An individual can invest in a sector-specific mutual fund or ETF, but if doing so, has achieved only diversification “within” the sectors of the market. Rather, to achieve further diversification “across the market”, he or she should invest in several mutual funds or ETFs.

Here is a table summarizing the characteristics of ETFs as compared to mutual funds:

EXCHANGE TRADED FUNDS (ETFs) VERSUS MUTUAL FUNDS