Asset Classes, Part IIB: Mutual Funds vs. ETF’s: The Final Showdown*

Never forget these two axioms:

Money frees us, but its pursuit may enslave us.
It’s not about how much you have at the end; it’s how much you could have made.

Asset Classes, Part IIB

Mutual Funds vs. ETF’s: The Final Showdown*

Think of your investment portfolio as a wardrobe.
It’s many different pieces (shirts, pants, socks, shoes, etc.) that cover all of you. Stocks, mutual funds, ETF’s, bonds, commodities, and many other items (all known as financial instruments) comprise your “financial wardrobe” so to speak.
Funds can be like that great piece of wardrobe that has many functions/pieces just as a fund may have many stocks or bonds or both in any combination.
But they can be structured very differently.

Open End Funds vs. Closed End Funds

Open End Funds=Mutual Funds

There. That’s it.

You’re welcome.

*Crickets*

*Puzzled faces*

OK. Fine. Let’s talk some more (eye roll so severely hard that you can hear it through the Interwebs).

Open end funds (which are typical/normal mutual funds) have no limit or end to the number of shares that it can issue. When someone buys shares of an open end fund (which you are buying from the fund itself), more shares are created (really out of thin air). When someone sells their shares of an open end fund, these shares are “retired” or taken out of circulation.
When a massive load of shares are sold within a short period of time (often within a day), the fund may actually sell/have to sell some part of its investments to pay for the amount of money owed to the seller(s). This is known as a redemption.
Though they’re usually composed of stocks, open end funds don’t trade/fluctuate like them. Open end funds reprice at the end of each weekday based on how many shares are bought or sold. (Simplistically thinking, massive buying of shares ups the price of an open end fund whereas massive selling of shares deflates the price.)
The price of the shares of an open end fund at the end of the day is determined by the total value of the fund based on the buying/selling of the shares throughout the day. This total value of the fund is known as the net asset value (NAV).

NAV=Total assets-Total liabilities/Outstanding shares

Total assets (i.e., all the stocks, bonds, etc. the fund owns)

Total liabilities (i.e., all the debt, borrowed money, etc. it owes)

Outstanding shares (remember this? What do you mean, no? Jerks! It’s all the shares of the [in this case] fund floating out there in the world for anyone to buy)

Realize that not only some stocks will produce dividends quarterly (or much more rarely monthly) which will be taxed, but mutual funds as well. (More on all of this in a later post.)

Closed end funds

Closed end funds, in contrast, have a fixed number of shares that do not increase or decrease depending on sales and are bought and sold among investors, not the fund itself, on an exchange
(i.e., marketplace). Like stocks, their share prices are determined according to supply and demand. They also are often at a steep discount (Yay!) or at a high premium (Whoa!) to their net asset value. (In all seriousness, realize that there is usually a reason something is really cheap [“it’s a porker”] or expensive [“you want quality, you have to pay”]. You just have to ensure that you’re getting value for the money you spend as you buy anything…anything at all.)
Just over 2/3 of closed end funds use borrowed money (known as “leverage”) to invest to bring about a bigger return to make the fund and, in turn, you money. So, anything that makes it more expensive for the fund to borrow money (e.g., higher interest rates, a fund being downgraded—more on this in a later post) will cost the fund more which will then be passed on to you one way or another thus lowering returns back to you as the investor.
Therefore, you have to watch quite a few things pretty frequently to ensure you’re in the right closed end fund and don’t need to avoid them or bail out of the one you’re already in.

Generally speaking, open end funds are safer and more predictable than closed end funds though their upside can be significantly higher than that of open end funds. Either can have dividends (though they’re more common in closed end funds), but those of the closed end funds are usually higher, but also far more likely to get cut depending on underlying conditions with that fund or the economy in general.

We will discuss investing in funds in a later post, but closed end funds are neither for the novice or faint of the heart.

Exchange-traded funds

Exchange-traded funds (ETFs) are similar to mutual funds because both group together securities (usually stocks or bonds) to offer investors diversified portfolios. Typically anywhere from 100 to 3,000 different securities can be grouped together to comprise an ETF.

SR: Uh, pal…That’s no different than a mutual fund. So what gives?

PWT: So here are the differences between mutual funds and ETFs.

SR: Finally!

ETFs are just like stocks in that they fluctuate throughout the day while, if you remember, mutual funds trade only at the end of the day at the net asset value (NAV) price.
Most (but certainly not all) ETFs track to a particular index and therefore have lower operating expenses than actively invested mutual funds. ETFs have no investment minimums (which mutual funds often do—i.e., you can’t buy any shares of a particular mutual fund unless you fork over what they demand such as $5,000 or $10,000).
Also, some mutual funds charge for the privilege of owning some shares of the fund (sales “loads” as you purchase the shares [front loaded] or as you sell the mutual fund shares [back loaded] vs. ones that don’t charge at all [no load]) whereas ETFs do not. Lastly, once you sell a stock or mutual fund, you are charged capital gains tax on it (much more on this in a later post), but that’s not the case with ETFs necessarily.
As you sell the shares in your ETF, the ETF doesn’t actually sell any shares (stay with me here), but rather creates and then offers to sellers what is known as “in-kind transactions or in-kind redemptions” which are often not taxable. Therefore, ETFs allow you to either significantly reduce or altogether avoid taxes on your way out of the ETF.

Here are the differences summed up in table fashion for all you bottom line chart/table/graphics learners out there. (Yeah, you know who you are. I went to med school too, people.)

ETFs                                                           Mutual Funds

Trade during trading day           Trade at closing NAV
Low operating expenses             Operating expenses vary
No investment minimums        Most have investment minimums
Tax-efficient                                   Less tax-efficient
No sales loads                                 May have sales load

Both open end and closed end funds have been around for decades, even a century. Closed end funds are the oldest type of fund debuting in the late 19th century.
Exchange traded funds, or ETFs, are the Johnny Come Latelys (Latelies? Who really knows how to spell these made up colloquialisms?) of the fund world being introduced just over twenty years ago.

Mutual funds are MASSIVELY popular. And why not? They allow you to invest broadly in the economy (US or global) or any part of it as you desire (e.g., technology, energy, utilities, etc.).
Currently, 7,467 open end funds exist with total net assets of $12.1 trillion (Yes, Trillion with a capital T—that’s $1,000 billion for those of you keeping track at home) as per Morningstar, the most well-known investment firm in the business.
In a relative sense (and only in a relative sense), the ETF market is small: roughly $1.7 trillion placed in 1,550 ETFs.
But closed end funds by far have the smallest amount in terms of both the number of funds and total assets: 568 funds worth about $252.6 billion (not even a measly trillion dollars; wealth just ain’t what it used to be.)

I think we’ve all had enough for one post.

I’d love to hear from any and all of you about your thoughts, so we can all learn from one another.

Talk to you soon.

*My favorite Europe song of all time.** What a hair band!! Too bad they broke up in 1992…and then got back together!! And are now still touring around somewhere…somehow…

**It was actually The Final Countdown, but whatever. Still good fun. Though it was always unclear what they were counting down to as they had already launched off Earth early in the song as per the lyrics. The countdown to their oxygen running out? Maybe. But that’s probably just the Pulmonary/Critical Care guy in me coming out unnecessarily again.