What are “Mutual Funds and ETFs”?

Both mutual funds and exchange traded funds or ETFs are collective investment vehicles that offer investors the ability to invest in a basket of different securities in a single trade, and can be used to diversify risk or to gain a specific exposure type. They are very popular among both retail and institutional investors and offer access to various asset classes such as equities, fixed income, commodities, real estate and many others. However, there are some fundamental differences between the two structures.

Key Learning Points

  • Mutual funds primarily adopt active strategies, where the fund is managed by an individual (or a team) who aims to generate more return for the fund than a particular benchmark
  • ETFs typically follow passive investment strategies, whose objective is to closely track a specific market index
  • Mutual funds generally charge higher fees than ETFs due to the additional costs associated with following active strategies.
  • Historically, mutual funds have added more value in more specialist and inefficient areas of the market, and during period of market stress
  • ETFs offer great value for investors who would like to gain pure market exposure and have stricter pricing criteria

Mutual Funds

The vast majority of mutual funds are actively managed and aim to deliver returns in excess of a particular benchmark or market index. They are priced once a day and typically trade at (or very close) to their Net Asset Value. Mutual funds have open-ended structure, meaning they can issue new or redeem existing shares in-line with investors’ demand. In addition, their fees structure tend to be on average more expensive than ETFs, due to the additional costs associated with following active strategies, since running an active fund involves hiring investment managers with deep industry expertise, as well as the transaction costs associated with a greater level of trading activity.

Exchange Traded Funds (ETFs)

ETFs have the objective of tracking closely a designated market index and are the preferred instrument for most passive investors. Along with their extremely competitive cost structure, these products offer intraday trading which gives them competitive edge from liquidity perspective. It is also possible to short sell and ETF, which is not possible with a mutual fund.

There are three major methods used to build ETFs – physical replication (buying all securities from an index, typically used for indices with a smaller number of constituents), stratified sampling (buying a selection of securities from the index with the aim of mimicking the performance of the index) and synthetic replication (buying derivative instruments in order to track the index).

Active vs Passive Investing

This is probably the most heated debate in the investment industry. Passive investing has grown in popularity in the recent years due to extremely competitive fees, a number of studies indicating that active funds underperform passive funds on average after fees and good performance on the back of rising markets.

However, investing in actively managed funds could be very helpful during periods of market turbulence, when outperformance may be critical for investors.

The best result may be achieved by combining active and passive strategies in a way that could leverage the advantages of each “world”. Historically, active managers have struggled to outperform within more efficient segments of the market, such as large companies within developed economies. As a result, it may be more appropriate to use passive products for gaining exposure to such well-established firms.

On the other hand, active managers might be in a better position to add value in more inefficient markets or sectors, where information barriers are higher and a more specialist skill set is required. For example, smaller companies, emerging or frontier markets, and sector-specific strategies.

Overall, the investor’s objectives and end-goals must determine what instruments constitute the best investments for an individual. For those, who prioritize reducing fees and trading costs an entirely passively managed portfolio may be most appropriate. For those who are willing to pay higher fees for the possibility of earning higher returns, a mixed approach could deliver better performance.