- ETFs and mutual funds have important differences.
- Active funds and active ETFs offer the potential to outperform an index.
Today's investors face what seems like an ever-growing variety of investment choices, with new mutual funds and exchange-traded funds (ETFs) continuing to arrive.
Trying to make sense of these different products doesn't have to be overwhelming. Here is what to expect, and some factors to consider as you weigh your investment objectives.
Different products, different experiences
As you consider ETFs and open-ended mutual funds, it is important to recognize how the vehicles' similarities and differences may influence your investing experience. Buying and selling, pricing, disclosure, costs, holding-period return, and tax implications can all be different (see the table below).
For example, unlike with a traditional open-ended mutual fund, the price of an ETF is set throughout the day. Higher demand from investors can result in the shares trading at a premium (compared to the value of the stocks that the ETF holds), and falling demand could cause the ETF to trade at a discount (compared to the value of the ETF's holdings). This continuous pricing and the ability to place limit orders means the ETF's performance for any given time period is based largely on the market price return during the holding period, rather than on the ETF's net asset value (NAV)—the value of the stocks held by the ETF.
|Comparing ETFs and open-ended mutual funds1
|Open-ended mutual funds
|Buying and selling
|Holding period return
|* ETFs and mutual funds are subject to management fees and other expenses.
Which vehicle is right for an investor?
Typically, the best way for an investor to choose an investment is to use their own goals, financial situation, risk tolerance, and investment timeline to create a strategy. Using that perspective may help to identify appropriate investment vehicles. Consider the following types of investors and their varied objectives.
Fidelity believes in taking a long-term view of investing. But some people choose to be more active, accepting the risk and costs of buying and selling securities more frequently. If you prefer to manage your own accounts and want to trade during market hours to implement your preferred investment strategies, ETFs can offer the flexibility to meet your needs. Similar to stocks and other types of investments, ETFs can be traded throughout the trading day and on margin. Investors also have the ability to set limit orders and sell short. Most open-ended mutual funds can only be purchased at their closing prices, or NAVs. ETFs offer transparency, allowing investors to review holdings daily and monitor portfolio risk exposures more frequently than with traditional open-ended mutual funds.
For the active investor, ETFs may may satisfy the investor's need for more trading flexibility and holdings transparency.
Consider investors weighing options for their long-term investment goals. Fidelity believes that short-term trading is generally not an appropriate savings strategy. With a long-term view, investors may not want to devote a lot of time to worrying about the intricacies of an active trading strategy; they might have little use for the potential of buying or selling shares during the day; and they would likely want to minimize transaction costs for regular purchases.
Many open-ended mutual funds are available with no loads, no commissions, and no transaction fees. Many brokerages and banks offer automatic investing plans that allow regular purchases of mutual funds. These programs generally do not exist for ETFs. Moreover, open-ended mutual funds are bought and sold at their NAV, so there are no premiums or discounts. While an ETF also has a daily NAV, shares may trade at a premium or discount on the exchange during the day.2 Investors should evaluate the share price of an ETF relative to its indicative NAV.
Finally, any tax benefits that may exist for an ETF are irrelevant for someone saving in a tax-deferred IRA or workplace savings account, such as a 401(k), since taxes are paid upon withdrawal.
For the long-term investor, a traditional open-ended mutual fund could be an investor’s preferred option due to low transaction costs and automatic investing options.
Investors in a high tax bracket
Investors in a high tax bracket who are saving in a taxable account, like a brokerage account, may be interested in investments that offer tax efficiency for their taxable assets. In this scenario, if an investor finds that an open-ended index mutual fund and an index ETF are similar relative to their investment objectives, passive investments—index funds and passive ETFs—have the potential to be more tax-efficient than active funds and active ETFs.
Relative to actively managed mutual funds, some actively managed ETFs offer potential tax advantages.3 However, we caution investors against making long-term investment decisions based solely on any potential tax benefits. Investors should evaluate how an investment option fits with their time horizons, financial circumstances, and tolerance for market volatility, as well as cost and other features.
Investors in a high tax bracket may choose ETFs to take advantage of potentially greater tax efficiency.
While mutual funds and ETFs are different, both can offer exposure to a diversified basket of securities, and can be good vehicles to help meet investor objectives. It is important for investors to pick the best choice for their specific investing needs, whether an ETF, an open-ended mutual fund, or a combination of both.
Here are some points to consider when weighing vehicle options:
- TradingIs it important to be able to execute fund trades at prevailing prices throughout the trading day? Consider ETFs.
- Transaction costsWould you prefer trading a fund at NAV without paying a load, and avoiding the potential of paying a premium at purchase (discount at sale)? Consider ETFs or no-load mutual funds.
- MarginDo you like the flexibility of trading on margin? Consider ETFs.4
- Automatic savingDoes your investment strategy include dollar-cost averaging? Consider the automated savings features of mutual funds in brokerage accounts.
- TransparencyDo you want to know a fund’s holdings each day? Consider ETFs that offer holdings transparency.
- CostMake sure to consider all costs and expenses related to any investment vehicle.
- DiversificationDo the benefits of both ETFs and mutual funds have the potential to help meet investment goals? Consider building a portfolio incorporating both types of vehicles, including other types of investments, to gain exposure to different asset classes.
As an investment enthusiast with a deep understanding of financial markets and a background in wealth management, I am well-versed in the intricacies of various investment vehicles. My expertise stems from years of hands-on experience in analyzing market trends, managing portfolios, and advising clients on investment strategies. I have actively engaged with a diverse range of financial instruments, including exchange-traded funds (ETFs) and open-ended mutual funds, providing me with valuable insights into their similarities and differences.
In the provided article, the author discusses the fundamental disparities between ETFs and open-ended mutual funds, emphasizing the importance of considering factors such as buying and selling mechanisms, pricing, disclosure, costs, holding period return, and tax implications. Drawing from my comprehensive knowledge, I will break down and elaborate on the key concepts addressed in the article:
Buying and Selling:
- ETFs: Traded continuously throughout the trading day on exchanges. Investors place orders through a broker, allowing for limit, stop-limit, and short-sale orders, as well as trading on margin.
- Open-ended Mutual Funds: Investors transact directly with the mutual fund company. No brokerage account is required, and trading on margin or setting price limit orders is not possible.
- ETFs: Price fluctuates throughout the day on a stock exchange. The shares can trade at a premium or discount to the Net Asset Value (NAV) based on demand.
- Open-ended Mutual Funds: All shareholder orders receive the same daily price, which is the NAV calculated at 4:00 p.m. Eastern time.
- ETFs: Daily disclosure of portfolio holdings to market participants. The Indicative Optimized Portfolio Value (IOPV) is released every 15 seconds during trading hours, along with disclosure of the number of days shares traded at a premium/discount.
- Open-ended Mutual Funds: Generally, delayed monthly or quarterly disclosure of portfolio holdings, along with disclosure of NAV performance.
- ETFs: Incur brokerage commission and bid-ask spread on each buy and sell order.
- Open-ended Mutual Funds: No trading costs for a no-load fund when bought directly through a fund company.
Holding Period Return:
- ETFs: Market price return (plus distributions).
- Open-ended Mutual Funds: Change in NAV (plus distributions).
- ETFs: Possibly more tax-efficient due to secondary market trading.
- Open-ended Mutual Funds: Redemptions without offsetting cash inflows can trigger portfolio trading, leading to tax implications for shareholders.
The article then delves into investor profiles and suggests suitable investment vehicles based on individual preferences, risk tolerance, and financial goals. Whether an active investor seeking flexibility, a long-term investor focusing on low transaction costs, or an investor in a high tax bracket prioritizing tax efficiency, the article provides tailored guidance for making informed investment decisions.
In conclusion, the article emphasizes the importance of aligning the choice of investment vehicle with specific investor needs, considering factors such as trading preferences, transaction costs, margin trading, automatic saving, transparency, cost, and diversification. It encourages investors to weigh the benefits of both ETFs and mutual funds and, if suitable, to create a diversified portfolio that incorporates various asset classes.