Mutual funds and exchange-traded funds are both pooled investment solutions that can successfully offer an advisor's strategies to a larger group of investors. The two types of funds share many similarities, but are also different in numerous ways. Advisors need to understand the nuances of both to choose the right investment vehicle to meet their goals.
Mutual funds and some ETFs are registered entities under the SEC's Investment Company Act of 1940. An ETF needs an exemptive order from the SEC in order to operate, which influences its start-up costs significantly. A mutual fund's creation costs are less than an ETFs but can vary from fund to fund depending on whether they are created within a shared or series trust, or as a stand-alone fund. While a mutual fund can purchase or hold only the securities that qualify under the strategy listed in its prospectus, an ETF tracks an index, sector, commodity or currency that is outlined in its prospectus and is also allowed to hold securities outside of the tracked entity.
Both mutual funds and ETFs utilize an administrator, legal counsel, custody bank and board of directors in the creation process, although an ETF must also contract with an authorized participant or market maker. Both vehicles utilize an administrator, fund accountant and transfer agent in their ongoing operations.
The differences come into play with the buying and selling of the vehicles. Mutual funds are offered to investors on broker-dealer platforms, as well as from wirehouses and independent broker-dealers and direct from the funds' transfer agent. ETFs are offered via their market makers and ETF trading specialists, and are available to investors in the secondary markets.
The ins and outs of how each product operates are product-specific.
-ETF net asset values are calculated at the end of the business day based on value of underlying securities.Inter-day trading is based on bid/ask price, similar to stocks.
-Mutual Fund NAVs are calculated at end of business day based on value of underlying securities. Shares are bought at calculated NAV of the date of purchase.
-ETFs own an entire index to deliver beta of benchmark while mutual funds employ teams of analysts and strategies to outperform beta and generate alpha.
-ETF dividends are paid to investors' brokerage accounts. Then investors must complete another purchase to reinvest the dividends. These are often paid quarterly, but frequency is determined by advisor.
-Most mutual funds offer an automatic reinvestment option, but shareholders can opt to receive dividend payment. Required to pay dividends at least once a year, frequency is determined by advisor.
-ETFs can be sold short or long. Options contracts allow investor to call or put shares in the future at a specific price. Mutual funds can only be purchased at the NAV of the day the order is placed.
-ETF investors go to ETF specialists to browse list of available ETFs and ETF specialists take investors purchase order. Market makers then fill orders for specialist. Except for the initial purchase of new shares, all trades are between investors on the open market.
-Mutual Fund investors browse list of funds available to his brokerage account through the corresponding platform. Investor places order through account. Broker purchases corresponding shares for investor, or investor can purchase shares directly from fund.
In addition to how the funds work, there are also major differences in taxes, the expenses charged to shareholders and the amount of fund assets required to break even. Investors look to ETFs because the majority are passively tied to major indices and so usually have fees that are lower than mutual funds. The relatively few actively-managed ETFs in the marketplace have slightly higher expenses, but usually below the level of mutual funds following similar strategies. The fees for an ETF are usually .05% to .75%. The management fees for mutual funds vary widely based on the track record and type of fund. The average fee for a mutual fund is 1.3% to 1.5%, in addition to any loads the fund has as well as a 12b-1 fee, if applicable.
A mutual fund, not including sales and marketing costs, needs to have around $15 million to $20 million in the fund to cover operational costs. An ETF needs around $50 million to $75 million, excluding their advertising costs, to cover operational costs. To an advisor, there are also major differences in the fund's taxes. For ETFs, capital gains tax is paid on sales, and completely up to the investor. An in-kind transfer of ETF shares for underlying securities between the fund custodian and AP does not incur capital gains. Mutual funds are required to distribute capital gains to shareholders if underlying securities are sold for a profit. Taxes are usually incurred when shareholders want cash and liquidate their position in the fund.
Both ETFs and mutual funds are pooled investment solutions that offer diversification to investors, but each has very different characteristics.
Before advisors decide which one is ideal for their firm, they should evaluate the needs of their investors to determine the most profitable strategy and distribution options.
Andrew Rogers is CEO of Gemini Fund Services, LLC, an engaged partner to independent advisors providing comprehensive, pooled investment solutions.
