Investing Basics

ETF versus Mutual Fund: What You Need to Know Before Investing

by Alex Spence
October 11, 2020
PFP® - Business Development Associate, Scotia Wealth Management
October 11, 2020

ETF versus Mutual Fund Summary

The differences between these two investment vehicles are often overestimated. Ultimately, they are vehicles through which financial companies can deliver portfolios to interested investors. There are thousands of offerings in the marketplace so understanding the differences between them and how they can stand to potentially compliment your portfolio is of utmost importance.

What is a Mutual Fund?

A mutual fund is pooled investor money, managed by a professional in accordance with the mandate outlined by the fund’s investment objective. Mutual fund prices are updated once daily, after the stock market has closed. Any mutual fund units purchased that day will be priced at that ending price for the fund that same day. Mutual funds come in different classes which are available through different distribution channels including: retail banks, wealth management firms, and online discount brokerages.

What is an ETF?

Exchange Traded Funds (ETFs) are securities that trade throughout the day on an exchange, just like individual stocks. The value of each unit is based on the basket of securities which the ETF tracks. These securities are often listed in an index, however, as financial products continue to evolve actively managed ETFs have become available and increasingly popular.

The Costs

A common misconception is that the cost to invest in mutual funds or ETFs is different simply because one is a mutual fund and one is an ETF. The cost of an investment is typically expressed as a Management Expense Ratio (MER). While it is true that you’re unlikely to find a pairing of a mutual fund and ETF with the exact same MER, that is not necessarily because they are different types of securities.

Historically, ETFs were viewed as cheaper and cost effective because they were predominantly passive investments. Meaning you weren’t paying a professional portfolio management team to actively select investments which go into the basket being tracked by the ETF. The basket was predetermined by a listing (index) of securities. This made ETFs cheaper than their actively managed mutual fund peers. However, as mentioned above, as financial products evolve, passively managed mutual funds and actively managed ETFs have become available.

The Functionality

There are different factors an investor should look at when evaluating an ETF in comparison to a mutual fund:

1. First and foremost, do you want to invest in a predetermined index, or would you rather active management by a portfolio manager?

2. What is the cost to invest in the portfolio? Remember, a passive investment generally should be less expensive than an active investment within the same asset class or geographic coverage region. Note that a cost that is often not considered is if a fund holds cash within its asset mix, either to satisfy investor withdrawals or for opportunistic deployment. Holding cash essentially means less of your money is being invested and cash within the fund structure forces your hand to pay a management fee for money that’s not being invested.

3. What is the portfolio’s track record? With passive vehicles – although they intend to track an index – there will be a certain amount of “tracking error”, which is the difference between the actual experience of the investor and what result the index produces. This can be due to fees, the portfolio’s responsiveness to updates in the underlying index, or by efforts on the behalf of the fund provider to reduce tracking error. An actively managed portfolio can be compared to its passive equivalent; did the portfolio manager deliver either excess returns or reduced risk for the fee they’ve been paid?

4. We have also recently observed another quirk of passively managed ETFs, which is their ability to have a price which does not reflect the fair value of the underlying holdings. As ETFs trade throughout the day in an environment where sellers outweigh buyers, the price of the ETF will begin to fall, even if separately the holdings of the ETF are unchanged. However, an ETF will typically return to its net asset value after whatever volatility created an imbalance of buyers and sellers subsides.

In conclusion, it is important that an investor understand their goals and their risk tolerance before finding an investment portfolio that fits those parameters as opposed to going backwards and selecting a type of investment prior to having well defined parameters.

About Alex Spence

Alex Spence, PFP®, is a business development associate with Scotia Wealth Management. Based out of Winnipeg, Alex’s practice serves clients across Canada. Alex focuses on helping professionals accumulate, preserve, and pass on their wealth to future generations. If you’d like to learn more about wealth planning, you may contact Alex directly.

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