Mutual Funds vs Exchange Traded Funds | Which Do You Want?
Mutual Fund vs Exchange Traded Fund? There are basic differences you should know.
We talk about why the two forms of investment have developed over time, when ETFs are better than mutual funds, when you must use mutual funds, and finally some new developments that you should know about exchange traded funds, especially if you're interested in socially responsible investing (SRI) or Environmental Social and Governance investing (ESG)
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Bridget: Exchange Traded Funds and regular mutual funds. What's the difference? That's what we'll be talking about today on Friends Talk Financial Planning. By the end of this episode, you'll understand both what we think you should pick and why we brought this up. In my opinion, there's a significant new offering that maybe you should be thinking about. I'm Bridget Sullivan Mermel, and I've got a fee-only financial planning practice in Chicago, Illinois.
John: And I'm John Scherer. I've got a fee-only financial planning practice in Middleton, Wisconsin. And before we dig into Exchange Traded Funds versus mutual funds, I want to remind everybody to hit that subscribe button. Subscribing to our show helps other people find this content on YouTube. So hit subscribe, and then let's get into talking about Exchange Traded Funds or ETFs, in our language. And it seems like ETFs are a fairly new thing in the investment world, but they've actually been around for a long time. And why don’t you start the conversation, Bridget, about how we think about these things.
Bridget: Yeah, when I'm explaining this to clients, what I say is that when mutual funds first started, a company would set up a mutual fund and everybody would send in their money, and then at the end of the day the company would invest it. The company would figure out what it was all worth, and people would send in their money, or ask, “I want redemptions. I want to take some money out.” And every night, the people at the fund company would put their heads together and figure out, okay, what is the closing price? How many people are coming in? How many people are going out?
And then they come up every night with the price at the end of the mutual fund. As far as I know, regular mutual funds started in the 70s, but possibly back to the 50s. When computers started getting better, however, there was a demand for something that's a little more current. And so, what happened in the ‘90s is that the professionals decided to start experimenting with funds that are traded on the stock market, on the New York Stock Market.
So instead of sending your money into the company, it's there and you buy it just like a stock. And so instead of sending your money into the company, you have an agreement with your brokerage house, like Charles Schwab or whoever, and then they go ahead and buy it on this stock exchange, again, just like a stock. It took computers for this to happen so that the computer can answer the question, “Is this worth it at all times?” And then for buyers and sellers to have a ready market for this basket of funds or a basket of stocks in the market.
This started in the 90s, mostly for professionals, but then other people wanted them, and there was enough trading on them so that there would be a ready market for them and there wasn't a big spread between the buy and the ask. And so, they became just generally accepted. I know I started my fee-only financial planning practice in 2008, which was close to when Vanguard started offering ETFs, and we've been using them since the beginning. John, what do you think? What do you tell people?
John: I tell people that Bridget is a lot smarter than I am because she understands all that background stuff. I started my practice a few years before Bridget did. We started with mutual funds, and now most of our new investments, at least in the brokerage side, are in the ETFs. And really my memory of what went on is ETFs were originally touted, as I remember it anyway, as something that you can buy immediately.
Mutual funds only trade at the end of the day, so if you want to buy mutual fund right now, at whatever time it is you're watching, it's a close of business, either today or tomorrow if it's at night, whereas ETF, as soon as you buy it, you have it. As you described, it buys like a stock, so you can buy in and out whenever you want to. That doesn't sound very exciting to me. Who cares exactly when you get the purchase price unless you're timing the market, which we don't do and don't recommend? The advantage that we really saw in it is that the way they structure ETFs compared to the mutual fund is that at the end of the year mutual funds are required to distribute their profits inside their fund to shareholders.
If you own mutual funds, you might get those 1099s at the end of the year, and you have to pay taxes on your capital gain distributions even if you didn't sell anything. Generally speaking, however, ETFs don't have that. So they both have very similar underlying structures—with professionals managing the funds—but it's much more tax efficient to have ETFs, and that's the real reason that we use them today for folks: the tax efficiency of not having these big tax bills every year like when you have mutual fund distributions. So that's a real advantage or where we see it in practice.
And as I look at it, the funds that we use anyway, and I know you use a lot of similar funds, have basically the same management, the same underlying index type fund, the same philosophy as I look at it. And it's not the case for all ETF versus mutual funds, but for the ones that I use anyway, it's mutual fund or ETF; they’re the same for the most part. It’s a matter of this type of apple versus that type of apple. It's not even apples to oranges. It's apples to apples, just a little different flavor, one that's a little bit more tax efficient. We're getting the same investment with a different tax wrapper around it. So that's largely how we think about it, even if the technical details are a little bit off from that.
Bridget: Yeah, and I would say that you will still get dividend distributions, and so you'll still have to pay tax on some, even with the ETF, but it separates out the capital gains. And so, then you have control over when you take the capital gains. Or maybe there's an advantage to doing tax loss harvesting when the stock market is down, but when you have a mutual fund, a regular mutual fund, you don't have that same opportunity. It's more baked into the actual fund. Again, you don't have control over the dividend part, but you have a lot of control over the capital gain with ETFs. And I think over time, the capital gains are a bigger factor than the dividend part anyway.
John: Here's how I describe this. It is really interesting to have this look behind the conversation. I find people don't know what an ETF is, it's like I'm talking a foreign language, but people know mutual funds.
John: And if you were to go back into the ‘70s, people would say, “What's a mutual fund? You buy stocks.” Now everybody kind of knows about mutual funds. I explain it to people by saying, “An ETF is pretty much just like a mutual fund with some technical differences that benefit you.” Do you think that’s a fair explanation for a regular person? Can we say it's like a mutual fund, but it's just slightly different for some tax reasons?
Bridget: Yeah, I would say that's fair.
Bridget: I would say another thing about mutual funds is that, as far as I've seen, mutual funds are what is available for 401Ks. Maybe it's because they don't want people trading all the time, but in any event 401Ks typically have traditional mutual funds.
John: There's got to be some technical difference of the execution or something, right?
Bridget: Yeah. So I end up looking up the old mutual funds because of the 401Ks. And then there's some investments that are only available in mutual fund form, and they're not available in Exchange Traded Funds. And sometimes it's because the outfit that is putting these together doesn't want them traded that much. So one of the things that we wanted to talk about is what even sparked talking about this? And for me, we use Dimensional funds a lot, and Dimensional Fund Advisors has started putting out Exchange Traded Funds.
So Dimensional Funds Advisors’ funds have not been available to the general public. It's only been available through advisors like us—we both offer them. And I'm not promoting Dimensional funds any more than I promote Vanguard or any other mutual fund, but I will say that though they haven't been available before, they are available now, and they're worth a look. Also, the one particular fund, if you're interested in this kind of thing, that's worth a look is their Exchange Traded Fund for sustainable investing.
Again, I'm not recommending that more than any other, but it's something that's new on the market, and they've had a long history with sustainable investing with a regular mutual fund. And this particular type that they use hasn't been available to the general population because it was only available through people like us. So that's what got me thinking about this. I was said, “Wow, this is actually big for the industry. These are starting to be available.”
John: I wanted to pick out just a couple of things that you said in there. Is there a reason why you would use a mutual fund versus an ETF, especially in a taxable account? And as far as we can figure, the answer is no. The ETFs are generally preferable. One key exception is if you can't get that type of a fund you want in the ETF version, then it does make sense to have the mutual fund version.
What you just described with the Dimensional sustainable funds. You're a great resource on that for me, and I don't mean to put words in your mouth, but DFA does a really good job of producing sustainable funds. So if this is something you want to do, now you can. Before this, there was no ETF version. Now we have an opportunity to say, “Well golly, I want to invest in sustainable funds.” If you really think that their sustainable strategy for investing makes a lot of sense, now you've got this opportunity to do that.
Bridget: Right. And I want to make clear I don't want to recommend it, but I do say it's worth investigating. The other thing we haven't mentioned yet is that the fees are typically a bit lower with ETFs than they are for mutual funds. So that's why even in IRAs and Roth IRAs, where you're not worried as much about the capital gain—exactly what's capital gains, exactly what's dividends—because it doesn't really matter that much in those accounts, the fees are generally lower for ETFs than they are for mutual funds.
I think the reason is because it takes lessens burden of record keeping for the people who are managing the funds and puts it on the more efficient stock exchanges. And so, they pass along the savings to you. It seems to me, however, that the cost of mutual funds has come down, probably because of the competition from Exchange Traded Funds.
Bridget: I think it's maybe a great place to wrap up. When you hear Exchange Traded Funds or ETFs, think it's like a mutual fund, but probably with some more tax efficiency and lower fees, so it's something that's worth looking at from that standpoint. So with that, I'm John Scherer, and I run a fee-only financial planning practice in Middleton, Wisconsin.
Bridget: And I'm Bridget Sullivan Mermel, and I've got a fee-only financial planning practice in Chicago, Illinois. We're both members of ACP, or the Alliance of Comprehensive Planners. If you're looking for an adviser in your area, you can check out acplanners.org.
John: And don't forget to hit that subscribe button.
At Sullivan Mermel, Inc., we are fee-only financial planners located in Chicago, Illinois serving clients in Chicago and throughout the nation. We meet both in-person in our Chicago office and virtually through video conferencing and secure file transfer.