The difference between ETFs and mutual funds
Exchange-traded funds (ETFs) are increasingly popular among investors. But are they right for your savings goals? To help you decide, we explain the key differences between ETFs and mutual funds.
Exchange-traded funds (ETFs) are taking the financial markets by storm [French only]. You may have already invested in one! Like mutual funds, ETFs are composed of many different assets, but it's important not to mix the two up. With both products, the same basic principle applies: individuals invest their money so it can be managed by an expert. However, as a general rule, the associated costs vary widely. Here's why.
Why do ETFs tend to be so much less expensive than mutual funds?
While there are various types of ETFs and mutual funds, each with their respective goals and management styles, the key difference between them is that mutual fund share prices are calculated only once per day, whereas ETF share prices fluctuate all day until the market closes.
Initially, ETFs were created to minimize investor fees. Many are index ETFs that simply replicate a benchmark index and require very little human intervention. Since index ETFs are considered passively managed funds, they tend to have lower fees. In most cases, ETFs track a stock market index, which is a list of stocks representative of a given market or activity sector. For example, the S&P/TSX 60 Index comprises the 60 largest companies listed on the Toronto Stock Exchange and is managed by Standard & Poor's. It is the benchmark index of Canada's largest ETF, the iShares S&P/TSX 60 Index (XIU). ETFs can also track indices outside the stock market, including for bonds, commodities (e.g., gold), countries or regions, and currencies. The tracked index determines how assets are weighted in the ETF.
There are also actively managed ETFs. Instead of passively replicating an index, this type of ETF attempts to outperform the market while meeting a specific investment goal. Similarly, it's possible to invest in index mutual funds and actively managed mutual funds. It's therefore important to look beyond management styles to understand the difference between these two financial products.
How high are your fees?
The fee structure of a mutual fund tends to include compensation for a mutual fund representative. In other words, when you invest in a mutual fund, you can consult a representative at no extra cost. This service isn't available when you invest in an index ETF. If you wish to consult a financial advisor for help developing your saving strategy, remember to take their fees into account.
For the vast majority of ETFs, representatives don't receive an annual trailing commission. ETF management fees are usually about 1 percent or less per year. What's more, according to a 2019 study conducted by a global investment and portfolio management firm, 83 percent of global stock pickers consider low fees to be the biggest advantage to investing in ETFs.
Mutual fund management fees typically include transaction fees. As their name suggests, ETFs are traded on stock exchanges, so you need to pay brokerage commissions for the sale and purchase of different securities. Some ETFs absorb these costs, but on average, fees are set at around $10 per transaction. ETF management fees are generally low, but keep in mind that your monthly contributions, as well as brokerage commissions, can make a big difference on your final invoice. While ETFs are often considered to be good savings vehicles for long-term goals, they're less effective during your accumulation phase, when you're making multiple small transactions.
Mutual fund management fees include administration and operating expenses. These fees usually fluctuate between 1 and 3 percent and vary depending on your fund type, management style, and type of distribution. When you receive your fund's return, the management and administration fees have already been deducted. It's wise to pay close attention to your management fees, as they can vary from one mutual fund to the next. Plus, higher fees don't necessarily mean better returns.
Get to know your holdings
Remember that your broker must give you the ETF Facts no later than midnight on the second business day following the acquisition of shares. Save for some exceptions, if you've invested in a mutual fund, the Fund Facts must be provided in advance, and your fund manager should give detailed updates of your portfolio holdings twice a year.
In either case, the best strategy is to take the time to read all available documentation before investing. The Fund Facts, for example, contain key information about a mutual fund: its main features, risk profiles, past returns, fees, and more.
In summary, mutual funds and ETFs each have features that may suit your savings needs and align with your investor profile. The important thing is to know what you're investing in and to diversify your savings and investment vehicles. Before choosing an investment product, consider speaking with an expert for advice.
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