Four key differences between ETFs and Mutual Funds

By Michael Bronstine

Most investors do not build their portfolio around individual holdings as that can be a risky investment strategy due to a lack of diversification. Instead, many investors build their portfolio around a selection of investment funds. Mutual funds and Exchange Traded Funds (ETFs) are two of the most popular investment funds available, but investors should be aware of the differences and similarities between the two when using them as building blocks of their investment portfolio.

A brief history of ETFs and Mutual Funds in Canada

Exchange Traded Funds (ETFs) have become an increasingly popular option since they were introduced to Canadians in 1990. In fact, the Canadian market has been at the forefront of the ETF revolution. The first ETF in the world was an Equity ETF launched on the Toronto Stock Exchange in 1990, the first Bond ETF ever offered was launched in Canada in 2000, and the first Bitcoin ETF ever offered was launched in Canada in 2021. According to the Canadian ETF Association, as of April 30, 2022 there are now over 1000+ Canadian listed ETFs with over $338 billion CAD invested^[1].

Mutual Funds have been around much longer than ETFs, as the first Mutual Fund launched in Canada in 1932. Despite the continued growing demand for ETFs, Mutual Funds continue to hold the majority of Canadian investor assets. According to the Investment Funds Industry of Canada, as of April 30, 2022, there are over $1.9 trillion CAD invested in Mutual Funds^[2].

Both types of funds remain popular because there are so many different types of funds available to meet the needs of every type of investor. ETFs and Mutual Funds differ in many ways, but there are 4 general differences that often distinguish the two types of investment products.

Four differences between Mutual Funds and ETFs

1. Investment Styles

ETFs are synonymous with the revolution in passive investing because the first ETFs were mostly passively managed funds that tracked major equity indices like the S&P, TSX, Dow and NASDAQ. Passive investing meant that ETF products closely matched their indices so investors could count on getting average market returns instead of trying to beat the market. The ETF market has continued to evolve and now offers many different types of products that are not considered passive investments, but the biggest ETFs in the world continue to be passive index funds.

By contrast, Mutual Funds are known for being active because historically the products were built to provide investors with access to investment managers who would actively engage in trading. These funds were designed to beat the market by employing unique investment strategies. Today, there are also many different types of mutual funds, but the majority of them continue to be actively managed strategies.

2. Management Fees

As a by-product of being introduced as passive investing funds, ETFs typically had cheaper fees than Mutual Funds. This is because passive funds had lower Management Expense Ratios (MERs), which is the annual fee that investors pay for owning the fund. The MER accounts for cost of management, operations, and taxes. The MER of an ETF can vary widely depending on the type of investment strategy that is being used and the type of assets being invested in.

Mutual Funds often had higher MERs because there were additional costs that came with implementing the active investing strategy including research, analysis, insight, and the expertise of investment managers. As ETFs have continued to be popular with investors, both Mutual Funds and ETFs have found ways to reduce their MERs so that they remain competitive. Though on average ETFs are cheaper, it is important for investors to look at Fund Facts documents to understand the costs of owning the product.

It is important to remember that the MER does not include all fees associated with owning an investment product. Some funds can have additional fees based on commissions, trading fees and taxes depending on the type of fund you are purchasing.

3. Trading availability and access

One of the main reasons that ETFs have become so popular is their accessibility. Most ETFs do not have commission fees or investment or purchase minimums, so they are very accessible for investors who are investing with small amounts. Additionally, because ETFs are traded on the exchange, investors can purchase an ETF at any time throughout the trading day while the markets are open. Investors can see the price of the ETF fluctuate throughout the day so the investor may pay more or less than the actual (Net Asset Value) of the fund.

By contrast, Mutual Fund prices are set at the end of the day when the market closes. An investor can choose to buy during the day, but the actual transaction happens once the price of the Mutual Fund has been set based on the fund’s NAV at the end of the day. Some Mutual Funds also have investment minimums where an investor is not able to start buying mutual fund units until they have a certain amount of money. Some also include minimum holding periods where investors are unable to sell their units within a set time frame without incurring an extra fee.

4. Tax efficiency

In general, investors will have to pay taxes on income and capital gains distributions for the investments they hold. Since most ETFs are passive index funds, the fund engages in less buying and selling of underlying securities than actively managed Mutual Funds. This means that many ETFs incur fewer capital gains taxes that are passed on to investors. Minimizing capital gains can help improve long term returns.

Additionally, ETFs are uniquely structured to help make them more tax efficient for the individual investor. In most cases when an investor sells an ETF, it is sold to another investor via an exchange so the underlying holdings within the fund do not need to be sold. By contrast, when an investor wants to redeem their units in a Mutual Fund, the fund may have to sell its underlying holdings, which may result in additional capital gains.

The Bottom Line

When looking at investment options there are thousands of ETFs and Mutual Funds to choose from and every year that list is growing to meet the needs of investors. Both types of funds are great investment vehicles that offer core funds that investors can build their investment portfolio around. With so many investment options available, it is important that investors perform their own due diligence and research the funds to understand their offering, benefits and how they work with their investing strategy and account types.