Mutual Funds or ETFs?
Dr Krishna Gupta, YBB Personal Finance
It’s a hot topic, but first some information about mutual funds & ETFs.
Mutual funds are open-end funds (OEFs) that go back to 1920s. They are pools of stocks,
bonds & alternatives that are passively (indexed) or actively managed. They have annual
expense ratios (ERs) that are much lower for passive OEFs. The number of shares outstanding
isn’t fixed & the assets under management (AUMs) vary with purchases & redemptions. They
don’t trade but have listed exchange tickers & are bought & sold at the net asset values (NAVs)
at the NYSE market-close; the NAVs are published by the evening.
Mutual funds may have several CLASSES – Load (A-front, B-back, C-level), No-Load (NL),
Investor, Institutional, Retirement, Advisor, NTF/TF brokerage classes with different tickers, ERs
& purchase restrictions. But they have the common underlying pools, so their performances
differ just by their ERs.
Collective investment trusts (CITs) are also pools of securities. They don’t have exchange
tickers & have fewer reporting requirements than the OEFs, but they have lower ERs. The CITs
are offered within workplace retirement plans.
Exchange Traded Funds (ETFs) & Products (ETPs) go back to 1990s. They are also pools of
securities & alternatives that have ERs, but they trade on exchanges during the market
hours. This trading is among the institutional & retail investors with typical bid-ask spreads &
order matching & it doesn’t change the ETF AUMs. There are also authorized-participants (APs)
who can create or redeem large blocks of ETF shares by dealing with the ETF sponsors (& that
changes the ETF AUM); these keep the ETF premiums/ discounts within narrow bands. A
unique advantage of the ETF structure is that the creation/ redemption can be done in-kind &
without any tax consequences, so the ETFs are more tax-efficient than the OEFs. The ETFs may also use cash creation/ redemption that will involve taxable realized CGs. The ETPs cover a broader group of assets.
Most ETFs are still passive & use standard or customized indexes, but active ETFs have been
growing rapidly after the 2019 SEC ETF Rule. Amazingly, there are now more ETFs than listed
US stocks. Many ETF sponsors launch lots of strange ETFs but then shut those that don’t reach
viable $50-100 million AUMs.
There are other specialized funds such as closed-end funds (CEFs; mid-1800s- ), ETNs (index-
linked debt obligations), interval-funds (with restricted redemptions), nontraded funds (with
qualified buyers & restricted redemptions), separately-managed accounts (SMAs), variable-
annuities (VAs). Funds may be diversified or nondiversified according to the ICA 1933, ICA
1940 or the IRS/ Treasury rules.
Listed funds are regulated by the Securities & Exchange Commission (SEC, a securities
regulator). Their portfolio management, recordkeeping & administration, & asset custody must be by different firms, or by different subsidiaries/ units of the same firm. The separation of functions & periodic audits reduce the chances of fraud. The CITs are regulated by the Office of the Comptroller of the Currencies (OCC, a banking regulator). The SMAs & VAs may be regulated by the SEC & the state insurance commissioners.
The mutual funds (OEFs) offer simplicity, discipline (priced only at market-close), & allow convenient reinvestments of distributions at the ex-dividend NAVs. They have to distribute most of their realized capital gains (CGs) quarterly, semiannually or annually (common). When the markets are very active, the OEF managers change, the OEF objectives or benchmarks change, or there are large redemptions, then these OEF CG distributions may be quite large in December & that may disrupt tax planning; this is not a factor in tax-deferred/ free accounts.
The automatic/ systematic investment/ withdrawal programs (AIP/SIP & AWP/SWP) are easy to setup for OEFs. Workplace 401k/403b/457 mostly use mutual funds & CITs, but some have
started offering ETFs.
The ETFs benefit from their in-kind creation/ redemption process & may have no or low CG
distributions, so they are tax-efficient. Some ETFs are classes of OEFs & then both have similar
CG distributions. The ETFs are available commission-free at brokerages, but there may be
some required hold periods. Active investors can trade ETFs during the market hours. There
may be listed options on the ETFs. So, the investors can use more sophisticated & flexible
portfolio strategies with the ETFs. Brokers may offer distribution reinvestments plans (DRIPs)
through open market purchases a few days after the payout dates. Some brokerages may allow
AIP/SIP & AWP/SWP from brokerage core/ settlement funds only. Fractional trading is a recent
innovation, so the ETFs can be bought by dollar amounts at some brokerages, not just by share
numbers.
For more information, see https://ybbpersonalfinance.proboards.com/
