What Are Exchange-Traded Funds (ETFS)?

There are many investment “funds” in the global marketplace, which, frankly, can make it challenging for savers to determine which is right for them.

Moreover, there is a common misconception that the types of funds, e.g., mutual funds, index funds, and exchange-traded funds (ETFs), are all the same type of investment options. While there are certainly some similarities, there are also significant differences every investor should recognize before investing.

Active vs. Passive Investing

Investors (and investment managers) can choose between two main investment strategies: active and passive portfolio management.

Active portfolio management is just that: the portfolio manager (and team) often focuses on outperforming an index by "actively" making buying/selling decisions, adjusting asset allocation ranges, and employing other portfolio management techniques to meet a stated objective.

Conversely, passive portfolio management aims to replicate (or mirror) an index—neither outperforming nor underperforming its respective benchmark. Therefore, no portfolio manager is making active buy/sell decisions at the fund level.

Again, mutual funds can either be active or passive. If passive, they are called index funds. ETFs may also be considered passive or active.

Mutual Funds vs. Index Funds vs. ETFs

An active mutual fund is a diversified basket of professionally managed securities (hence, the "active" term) that employs a combination of stocks, bonds, and cash. Mutual funds are priced at the end of every trading day once the markets close at 4 PM EST.

On the other hand, index funds are designed to track a specific index, like the S&P 500 Index or Russell 2000 Index. Since they are technically mutual funds, they are also priced once a day when the markets close. And since index funds are not actively managed, they are typically cheaper investment alternatives, meaning they offer lower costs to shareholders than actively managed mutual funds.

ETFs, like index funds, are designed to track a specific index. But unlike mutual funds—including index funds—ETFs can be traded throughout the day like stocks.

What about fees?

Before discussing the differences in fund expenses, it's important to remember that almost 10,000+ different mutual funds, index funds, and ETFs exist in the marketplace, so it's impossible to speak in absolute terms about fees.

However, fees for index funds and ETFs tend to be lower when compared to mutual funds (generally speaking). In March 2021, the Investment Company Institute reported the following:

• Mutual fund expenses—The average expense ratio of actively managed equity mutual funds fell to 0.71%, down from 1.08% in 1996. The average bond mutual fund expense ratios fell four basis points to 0.42%.

• Index funds expenses—Over the same period, index equity mutual fund expense ratios fell from 0.27% in 1996 to 0.06% in 2020.

• ETF expenses—In 2020, expense ratios of index equity ETFs were 0.18% (down from 0.34% in 2009). Expense ratios of index bond ETFs, down from a recent peak of 0.26% in 2013, fell to 0.13% in 2020.

How about transaction costs?

First, we must note the difference between ongoing fees and transaction costs. As spelled out in the INVESTOR BULLETIN: How Fees and Expenses Affect Your Investment Portfolio, transaction fees are charged each time you enter into an investment transaction, such as when you buy a stock or mutual fund. In contrast, ongoing fees or expenses are charges you regularly incur, such as a management fee, operating expense, or annual account maintenance fee.

• Many mutual funds charge sales commissions—as high as 5.75% for Class A shares. Also, mutual funds might charge transaction fees of $10 or $75 per trade. Both depend on the mutual fund and how you're buying.

• Index funds don't charge sales commissions but might have similar mutual fund transactional fees. Again, it depends on the fund and how you're buying.

• However, ETFs are traded throughout the day, just like stock, charge fees every time you make a trade (buying and selling). These fees are generally around $5–$10 per trade, so the commissions on ETFs can add up for low dollar amounts or high-frequency trading.

Disclaimer: At ClearVue, we do not work on sales commissions; we are a fee-only investment advisory firm, meaning we will design and manage your investment account, charging an annual flat rate.

So, which is better? 

Truthfully, mutual funds, index funds, and ETFs have their upsides and drawbacks, depending on an investor's needs. However, all three are terrific tools that can work in unison when designing an efficient portfolio.

Let's set up a time to navigate the differences further and determine an appropriate strategy to help you reach your goals.

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