Mutual funds are one of the most popular investment vehicles used by Canadians. But over the past several years, another investment product, exchange-traded funds, have found a home in many investors’ portfolios. The following is designed to help you better understand the differences between these two important investment products.
A mutual fund pools investors’ money and hires a professional manager to invest this pool in a diversified portfolio of securities. Securities can be stocks, bonds, real estate, or almost anything that has financial value. When you invest in a mutual fund, you purchase units, in other words, you become a unit holder in the fund. One of the biggest benefits to owning a mutual fund is that all the research that goes into selecting the underlying securities and managing those investments is done by a professional money manager.
As a result, there is often a management fee, known as a Management Expense Ratio (MER), associated with investing in a mutual fund.
The fee will vary depending on the style of fund, type of securities held, and the tools that the manager uses to achieve returns. A mutual fund can be managed in either an active or passive style.
The portfolio manager of an actively managed fund tries to outperform the market, or index, by actively trading stocks in their portfolios to minimize losses in down markets or by taking advantage of growth opportunities when the market is performing well. Active fund managers have the freedom to select stocks or bonds from a predetermined investment universe. The portfolio manager of a passively managed fund does not try to outperform the market, or index, but rather tries to track it. Actively managed portfolios generally have a higher TER (Total Expense Ratio) as there is typically more trading, whereas with a passively managed fund, the work is less intensive and time-consuming and, as a result, the fees (including the TER and MER) are often lower.
The passive manager tries to hold all of the securities in a target index in the same proportions as the index and buys or sells each stock in their investment universe with this goal in mind.
This leads to what’s called “tracking error,” which is the difference in price between the universe of stocks they’re trying to replicate and the actual price of the stocks they hold. Remember a passive manager’s goal is not to beat the market, but to track it.
Similar to the passive manager who buys a universe of stocks to track or follow a market (or index), an exchange-traded fund also buys a universe of stocks.
The key difference is that an ETF is traded on an exchange, like an individual stock and priced continuously throughout the day. Investors can buy and sell an ETF like a stock whenever the exchange is open, whereas mutual funds are priced once a day at market close.
ETFs also can be sector specific which then allows you to be even more specific in your investment strategies. ETF’s are very transparent in nature because they often follow well-known indexes.
Investments styles of ETFs are always well known and established in advance, whereas a mutual fund’s investment style can be unclear at times.
A so-called “Growth Fund” is not restricted to only using companies categorized as such but may deviate from this objective depending on the portfolio manager’s views.
Like mutual funds, ETFs are a pooled investment and, similar to a passively managed fund, the MER is typically that less expensive because there is no research or “active” investment selection. It is important to note, however, that ETFs do charge a management fee and may also be subject to a broker’s trading fee.
These fees can quickly add up if an ETF is bought and sold frequently.
The decision to go with one of the investments above is personal and depends on your financial goals.
Each offers advantages and disadvantages and in some cases investors may want to consider complementing an active investment strategy with an ETF or vice versa.
Your advisor has a good understanding of these investments and a good understanding of you and your circumstances, and can be of help when it comes to deciding between mutual funds and ETFs.
Frank Zanatta is a CFP, Investment Advisor and Certified Retirement Specialist. For more information visit www.frankzanatta.ca.
