Everyone loves a buffet. At least I do.
Modern day investing is like a buffet – we have so many different kinds of investment products to choose from.
Let us look at the most common and popular investment products: Mutual Funds (or Unit Trusts) vs Exchange-Traded Funds (ETF)
Funds: The Buffets of Securities
If all your securities (stocks, bonds, commodities) are food, then funds are the all-you-can-eat buffets.
The main advantage of buffet over a regular a-la-cart meal at a restaurant is that you get to sample a variety of different dishes.
Funds allow the investor to hold a variety of securities in one product. When you buy a share of the fund, you buy a share of each security within the fund making you the owner of multiple securities. This brings about a benefit known as diversification.
The basic idea of diversification is that you spread out your risk by holding a large number of assets which are not correlated. So if one fails, chances are the others will still continue surviving.
Do not put all your eggs in one basket.
Mutual Funds & Unit Trusts
Mutual Fund: Is a company that pools money from many investors and uses the money to invest in securities such as stocks, bonds and short term debt and other assets
The definition of unit trusts depends on where you come from. If you are from the UK (or Singapore where I am from), a unit trust is basically a mutual fund.
I will be using mutual fund throughout this article but it basically is just unit trust
In Canada, however, the definition is different.
Unit Trusts: Is an unincorporated mutual fund where the assets and profits goes straight to the unit holders
Exchange-Traded funds: Commonly known as ETFs, it is a security consisting of a basket of securities (usually securities in an index) that is listed on exchanges and trades just like a stock – You can buy or sell them during trading hour.
ETFs are very similar to Mutual Funds in many ways. The main difference is how they are managed.
Let’s imagine mutual funds and ETFs as two different kind of restaurants that offer buffets.
Mutual Fund vs ETF
A mutual fund restaurant only opens during dinner at the end of the day. If you want to purchase a share of a mutual fund, you could only do it at the end of the trading day.
An ETF restaurants opens throughout the day. You can purchase a share of an ETF anytime you wish at your convenience within the trading day.
Shares Prices of the Fund
A term to measure the value of the underlying assets in the fund is Net Asset Value.
Net Asset Value: Known as NAV, it is the total value of all the assets in the underlying fund minus the liabilities. In other words, this is the net value of the fund.
The price of the mutual fund restaurant is calculated at the end of the day based on the costs of all ingredients used to make the dishes. The mutual fund then sells shares of their fund to investors based on this price calculation.
Some mutual fund restaurant requires a minimum order when you dine in. As an investor, you may want to take note of the minimum amount required to buy shares of a mutual fund.
The price of the ETF restaurant is not calculated by the restaurant but determined by the prices on the open market. Prices are not fixed and can fluctuate around the NAV.
So sometimes, it might be cheaper or more expensive to dine in an ETF restaurant compared to a mutual fund.
A mutual fund restaurant tries to beat market expectations. The chefs actively research to invent new recipes and create new dining experiences. Maybe one day, they will get the coveted Michelin stars. Given the exclusivity of the award, only a few mutual fund restaurants obtain the stars.
An ETF restaurant operates like a chain restaurant – it tries to replicate the same recipes and provide consistent dinning experiences to customers. The chefs follow a cookbook as closely as possible to ensure that their recipes meet expectations of their customers.
The funny thing about mutual fund restaurants and ETF restaurants is that the price covers only the value of the dishes in the buffet.
There are operating costs involved in running the restaurant, labour costs for the chefs and waiters, marketing costs for advertising the restaurant and many more.
The customer pays additional fees to the restaurant to cover these costs.
There are two kind of fees:
- Annual fund operating expenses
- Shareholder fees
Both mutual fund and ETFs have annual fund operating expense that charged to shareholders. These are referred to as expense ratios which are costs incurred to manage the portfolio.
As long as the investor continues to hold shares of the fund, the investor will pay these fees annually. So the costs add up every year!
Shareholder fees are one time fees incurred during buying or selling the mutual fund.
Mutual Fund Fees
Expense ratios include management fees, distribution fees, operating costs, administrative fees.
- Management fees: Paid to the fund managers and investment advisors
- Distribution fees (12b-1): Marketing costs and selling costs. Capped at 1%
- Other fees: Operating costs, legal fees, custodial fees, administrative fees
Typically, mutual funds tend to have higher expense ratios.
Shareholder fees includes commissions and other one time costs incurred during buying and selling of the fund. These typically are:
- Sales loads: Commissions paid when buying or selling mutual fund shares
- Redemption fee: This depends on the fund. Some funds require a fee if you sell within a short time frame
- Exchange fee: Some funds charges a fee to transfer from one fund to another fund offered by the same investment company
- Account fee: A fee charged if you account falls below a specified investment amount
- Purchase fee: Paid to the fund at the time of purchase
I know, that is a lot of fees. Sometimes, these fees are hidden in the prospectus (a formal document detailing all information pertaining to the fund). So you will have to do some due diligence before buying.
Further reading: Mutual Fund Fees : A Guide For Beginners
Similar to mutual funds, ETFs also have an annual expense ratio that is used to cover the costs of operating the fund.
Instead of shareholder fees, ETFs have brokerage fees when you buy and sell – just like a regular stock. These are also one time fees that are incurred during buying and selling of the shares.
On top of that, the bid-ask spread may also increase the cost of an ETF.
Bid-ask spread is basically the price difference between someone who bids (wants to buy a share at a certain bidding price) and someone else who asks (wants to sell a share at a certain asking price).
If there are not enough sellers or buyers, the best offer is limited and the seller or buyer has to take the offered price if they want to make the trade. This means you may not always get your bidding price or asking price causing the ETF to be more expensive.
This usually occurs to the less liquid ETFs. Liquid just means how much volume and how frequently traded the ETF is.
Further reading: etf investing hidden costs
Costs Comparison: Mutual Fund vs ETF
Due to the costs involved in researching and preparing new recipes, a typical mutual fund restaurant charges way more than a typical ETF restaurant.
However, that is not always the case.
There are index funds which are mutual funds whose aim is to replicate an index. These mutual fund tend to have lower costs than the typical actively managed mutual fund.
There are actively managed ETFs, just like actively managed mutual funds. These ETFs generally tend to have higher costs than a typical ETF.
Hence, cost is less dependent on the fund type (mutual fund or ETF) but rather the fund strategy (active or passive).
The fund strategy is stated in the prospectus and it should be one of the main points to look out for.
Open-End vs Closed-End Funds
There are two kinds of funds: open-end and closed-ended.
An open-end fund issues unlimited amount of shares. Usually the fund company directly sells to the investor.
Think of open-end funds like restaurants which have unlimited extendable space. They will keep opening up new spaces as long as there are new customers coming in.
A closed-end fund has a fixed number of shares. Just like a stock, the fund company raises capital via an Initial Public Offering(IPO). After IPO, the amount of shares are fixed and are traded on the exchange.
Think of it like a restaurant that has a limited number of seats. Once is it filled up they will no longer accept new customers. The existing customers have to leave the restaurant to trade seats for new customers.
Food for Thought
The advantages of having a diversified basket of securities, professional management and convenience (ETFs can be traded conveniently on exchanges) via these investment vehicles makes investing much easier and less riskier.
As a DIY retail investor, we should take advantage of these products to build our own investment portfolio.
However, the finance industry has not made it easy to understand these products.
So be sure to do your due diligence and understand each product before investing. Especially take note of the investment strategy and all hidden fees incurred.
I hope this article helps you understand these products. Do drop me a comment or feedback.
4 thoughts on “Mutual Funds and Exchange-Traded Funds”
I’d like your analogy of using restaurants to explain Mutual Funds vs ETFs – concise and very readable to the layman. Don’t think I’ve came across such a creative analogy before 🙂
(PS: Am trawling through your older articles =>)
Thank you. Glad that you found it interesting.