Exchange-Traded Funds vs. Traditional Mutual Funds

Traditional open-ended mutual funds have been around since the 1920s. Funds like Pioneer Growth A shares allowed investors to pool their money, give it to a professional portfolio manager and invest in a pool of stocks over time. Today there is a new type of fund trading on the exchanges. Exchange-traded funds comprise the next generation of passive investment mutual funds. 

Takeaways

• Which mutual fund share class is best for you

• Why exchange-traded funds are so compelling

• Risks you should be aware of

Comparison of features

Both types of mutual funds have some characteristics in common. This includes the pooling of investors' money, various types of investment risk (depending on the type of fund and what it invests in) and diversification of assets. Each share of both a traditional mutual fund and an ETF represents an undivided portion of ownership in each of the securities held by the fund.

But the similarities end there. Although both types of funds are at least relatively liquid, you can only buy and sell shares of a traditional open-ended mutual fund directly with the fund company. You may place the buy or sell order through a stock broker, but the issuing mutual fund company is always at the other end of the trade.

Exchange-traded funds trade like stocks on the financial exchanges and can be bought and sold at different times during the trading day. Their prices will fluctuate during intraday trading according to market conditions. Open-ended mutual funds have what is called forward pricing. The daily price of the fund is determined by the composite closing prices of all the securities held in the fund at the end of each trading day. ETFs are therefore more liquid than open-ended funds.

Watch those charges...

Many open-ended mutual funds also charge a sales load for those who purchase them. These sales charges generally range anywhere from 3 to 6 percent. There are a few funds that charge more or less than this. As a rule, any fund which charges a fee above 1% better have outstanding best-in-class performance. If they do not, they are making money and you are not.

Which share class do you want?

There are also different share classes that charge this commission in different ways. A share funds charge the sales load up front. The money is immediately deducted from the share balance. B share funds do not charge anything up front. Yet they come with a back-end surrender charge schedule that eventually declines to zero after a certain amount of time. C shares may charge a small amount up front and then another smaller amount when they are sold. All three share classes also charge annual management fees.

A shares are usually the cheapest class of share to buy over the long run. B share funds usually charge higher annual fees than A share funds, and C share funds usually charge higher annual fees than A or B share funds. There are also other classes of shares used by institutions.

Why Exchange-Traded Funds are simpler and cheaper

Exchange-traded funds do not come with these costs. Investors will usually pay a commission to buy or sell ETFs in the same manner they would as for a stock. ETFs are widely considered to be much more economical than traditional open-ended mutual funds because they have no sales charges (which are paid to the broker as a commission).

Pros and cons of open-ended funds vs. ETFs

Open-ended mutual funds have higher expense ratios and are less liquid than ETFs, but they often do better in bear markets than ETFs because they are actively managed. ETFs can get hit hard when the market tanks because they are passively managed investments.

Which is better?

The answer to this question depends largely on your investment objectives, time horizon and risk tolerance. Historical data shows that actively managed funds tend to outperform ETFs in bear markets, while ETFs are usually the winner when the markets are doing well.

There are some funds those performance over time is excellent that they are well worth a look. An example is Scottish Mortgage investment trust. Their holdings in thematic investing focused companies meant they performed strongly in 2020 and 2021, whilst also charging a fee under 0.5%. This fee is comparable to an ETF. In effect, investors got the benefit of active management with the low cost of an ETF.

The USO debacle

In April of 2020, the spot price of oil crashed so much, that it became cheaper to buy oil in the future than on the spot market. This is known as Contango. As a result the USO ETF which tracks the West Texas Intermediary (WTI) oil price crashed in value. The ETF held its positions using derivatives which it could not get out of due to the fall in demand in oil.

This fall in demand was exacerbated because WTI is a land stored commodity. Typically stored in giant tanks in Cushing, Oklahoma. When these tanks are full, then there is nowhere to store the oil. Traders were practically forced to pay people to take the derivative contract off their hands. (they do not want to left with a barrel of oil - unlike some!).

This highlighted the limitation of this particular ETF. This should be a lesson to all investors that just because an ETF tracks an asset price does not mean it will do so accurately.

Conclusion

Investors will have their preferences, but a mix and match of mutual funds and exchange-traded funds will often work best. This is because humans regularly fail to outperform benchmarks they are supposed to beat. It is therefore sensible to have the core of your portfolio in ETFs. Yet some fund managers do generate out performance so holding their funds will be beneficial.

The USO debacle has affected confidence in ETFs, but mutual funds had a similar negative event in 2019, when a star mutual fund manager had to close his fund down after serial poor performance. The lesson to be learnt, is whatever the composition of your portfolio you should always keep and eye on it.