A quick overview of what you need to know
Despite the attention that ETFs get in the personal finance world, mutual funds are still much more popular than ETFs. At the end of 2023, Canadians had $383-billion invested in ETFs but had more than five times that amount invested in mutual funds ($1.9-trillion).
If ETFs are so awesome (and they are), why would anyone still buy a mutual fund?
It’s a great question and the answer provides a lesson in understanding mutual funds and ETFs. Quite simply, mutual funds are more profitable. Not for you the investor necessarily, but for the companies selling them. Mutual funds are money-makers due to their high fees. ETFs are not nearly as lucrative.
It makes sense then that fund companies make it as easy as possible for someone to invest in a mutual fund. Mutual funds are sold in bank branches and through financial advisors, and are readily offered to anyone with money to invest.
ETFs on the other hand require investors to go the extra mile and open a self-directed brokerage account, and buy ETFs themselves. Although this isn’t hard, it’s a roadblock for people who have no desire to manage their own money.
The truth is that ETFs and mutual funds are really very similar. They are both structured as a pool of money that is invested by a fund manager. Investors buy units of the fund – the money that goes into the pool – and as the value of the investments go up, the value of the units go up and investors make money.
The concept is simple and the benefits are many. The primary benefit is instant diversification. It’s much easier to build a well-diversified portfolio with $1,000,000 than with $1,000. Funds can own anywhere from 20 to hundreds of stocks – individual investors would find it difficult to do this.
The other benefit is that you, the investor, doesn’t have to do anything. You don’t need to worry about how the price of oil will impact your Suncor stock or what Elon Musk’s latest comments on X means for Tesla. You don’t have to worry about interest rates, GDP figures, or who is going to win the AI race because you’re not making any decisions and choices about what stocks to own. The manager of the fund will look after that.
So what’s the difference between a mutual fund and an ETF?
The real difference is something that doesn’t get talked about very much because it’s pretty boring. It comes down to how the units are bought and sold. A mutual fund is only priced once a day at the end of the day. At 4pm, the value of the investments are added up and the total is divided by the number of mutual fund units outstanding. This is the price you pay to buy units of a mutual fund. ETFs on the other hand are priced continuously throughout the day just like stocks. ETFs can be traded all day long on a stock exchange – thus the name Exchange-Traded Funds. Mutual funds are not traded on an exchange – they are bought and sold from the fund company. Why does this matter? Some people like to trade in and out of investments all day long – day traders, they are called – and ETFs allow them to do this. As hard as it is to believe, some people actually want to trade ETFs throughout the day.
That’s the technical difference. There are some other differences which for most people are for more important.
Passive vs active: In my last blog post I wrote about passive versus active investing. Understanding this concept is crucial to understanding the difference between mutual funds and ETFs. That’s because mutual funds have traditionally been actively-managed and ETFs have traditionally been passively-managed. I say “traditionally” because there are passively-managed mutual funds (called index funds) and actively-managed ETFs. Yeah, confusing I know.
Fees: Fees on passive ETFs are always lower than on actively-managed mutual funds. Sometimes the difference is huge – the ETF that tracks the S&P 500 has a fee of 0.03% while an active Canadian equity fund can charge well over 2%. This is partly because it’s much easier and cheaper to manage a passive fund but it’s also because ETFs don’t pay an ongoing sales commission to the advisor who sold the fund. Many mutual funds pay a trailing commission, often 1%, and it is another reason why mutual funds are more readily available than ETFs.
Commission: When you buy a mutual fund, you probably won’t pay a fee up front. When you buy and ETF, though, you might have to pay a trading fee. Most of the bank brokers charge a commission (as much as $9.95 per trade) although there are brokers who offer some form of commission-free ETF trading. These include QuestTrade, WealthSimple, Scotibank, National Bank, BMO and TD (with their Easy Trade platform).
ETFs have a lot of benefits, and for people who are willing to manage their own money, they are a great choice. Mutual funds still have their place and are important too. Even though they are expensive and don’t always provide good performance, it’s better to be invested in a mutual fund than not be invested at all.