Are you looking to invest in funds but don’t know the key differences between mutual funds and exchange-traded funds (or ETFs)?
Both fund structures are extremely popular in Canada and across most of the world.
The S&P Indices Versus Active Funds (SPIVA) scorecard helps to track active (typically mutual funds) versus passive (typically ETFs) investments.
While active funds have been found to do well during short periods of market stress, active Canadian stock funds underperform 96% of the time over 5-year periods and 82% of the time over 10-year periods, as of June 30, 2022.
In this comparison, I will compare ETFs and mutual funds over the following categories:
- Tax efficiency
- Downside protection
I will cover ETFs vs mutual funds in Canada below and go through some of the key differentiating features.
ETFs vs Mutual Funds: the Basics
ETFs and mutual funds are both two types of pooled investments that Canadians can use in their portfolios. The differences between the two, which I will cover in further detail below, mainly have to do with how each fund operates.
ETFs were initially created with the original purpose of being passive investments. A passive investment follows a basket of investments (a benchmark), which is determined by a set of criteria and aims to replicate the performance.
A mutual fund almost always takes an active approach to investing. This means that the portfolio management team uses their skill and expertise to try and outperform a benchmark.
A mutual fund’s ability to outperform a benchmark (and, by extension, passive strategies like index ETFs) is mainly determined by the portfolio management team’s skill.
Some mutual funds may have excellent performance track records (which is rare), although most tend to underperform the broader benchmarks that they try to beat.
ETFs vs Mutual Funds: Fees
One of the most important categories for comparing both ETFs and mutual funds is fees. Actively-managed funds tend to be offered at higher fees, mainly due to the higher costs involved with a dedicated portfolio management team.
Since mutual funds are almost always actively managed, they tend to incur a lot more costs than the typical passive ETF. This causes most mutual fund fees to be high relative to ETFs. Fee pressure over the past several years has caused mutual fund fees to decrease.
ETFs are typically passive investments, meaning that they simply track an index or a basket of investments. With little involvement from a portfolio management team, these funds can keep their costs low and are offered to investors at low fees relative to mutual funds.
Fees verdict – When it comes to fees, ETFs are typically more inexpensive than mutual funds, making them a clear winner in this category.
ETFs vs Mutual Funds: Performance
Performance is another key consideration when investing in mutual funds and ETFs.
The fact that most ETFs are offered at a lower management expense ratio than the average mutual fund helps with long-term performance, especially when the savings in fees is compounded over time.
Active management does have the ability to reduce downside risk, especially if the portfolio management team is skilled in maneuvering the portfolio through difficult markets. I will look at long-term performance, using statistics from SPIVA.
Below are the 10-year statistics by different equity asset classes:
- Canadian equity: 82% of funds underperformed their benchmark
- Canadian-focused equity: 97% of funds underperformed their benchmark
- Canadian dividend and income equity: 79% of funds underperformed their benchmark
- US equity: 97% of funds underperformed their benchmark
- International equity: 93% of funds underperformed their benchmark
- Global equity: 96% of funds underperformed their benchmark
Performance verdict – Since the vast majority of actively-managed funds underperform their benchmarks over the long-term (10-year time horizon), passive ETFs are the clear winner in this category.
ETFs vs Mutual Funds: Tax Efficiency
The tax efficiency of an investment is critical to consider, especially if taxes have a large impact on your overall financial picture.
In general, ETFs are considered to be more tax-efficient than their mutual fund counterparts.
ETFs, especially if they are passively managed against an index, tend to have substantially lower turnover than actively-managed mutual funds. In most cases, capital gains that are accrued by a fund must be paid out to investors at the end of each year.
If a mutual fund receives a large redemption request (an investor wishing to sell their units), the fund must liquidate securities to generate cash for meeting the redemption.
An ETF investor that wishes to sell their position can sell it on the open market, like any stock, without implications for the ETF.
Tax efficiency verdict – When it comes to tax efficiency, ETFs typically experience lower turnover and can be traded with no impact at the fund level, making them the clear winner in this category.
ETFs vs Mutual Funds: Downside Protection
Investing through difficult market conditions can be very stressful if you are an emotional investor. Riskier ETFs and mutual funds (such as equity funds) can face significant drops in value.
ETFs, especially those that passively track an index, will drop in value by as much as the index that they are tracking. They do not have any risk-mitigating strategies in place since they are simply looking to replicate the performance of a basket of securities.
Actively-managed mutual funds that are designed to outperform a benchmark may shine when it comes to difficult market environments. Especially if the portfolio management team is seasoned, the mutual fund may be able to make tactical adjustments to its strategy to reduce losses.
It is important to look at a fund’s long-term performance in order to assess how skillful a portfolio management team is, especially during bear markets.
If a mutual fund has previously performed well during rough markets, it is possible that the portfolio management team (if it remains the same) may continue to do so going forward.
Downside protection – when it comes to downside protection, ETFs offer very little in this regard, while top-performing mutual funds may be able to protect capital on the downside. Mutual funds are the winner in this category.
ETFs vs Mutual Funds: Trading
ETFs and mutual funds trade in very different manners based on their underlying structure. ETFs are a lot more flexible in terms of their liquidity and ability to trade in most cases (for well-established ETFs).
Mutual funds do not trade like stocks on an exchange. Mutual funds trade once daily, typically after market close, which is executed at the mutual fund’s new net asset value.
A mutual fund’s new net asset value is typically calculated once markets are closed. Mutual funds also sometimes have minimum investment requirements.
ETFs trade exactly like stocks and are listed on an exchange. ETF units can be bought or sold at their respective ask and bid prices anytime during the trading day (when markets are open). The minimum investment for an ETF is usually determined by its unit price.
Since ETFs trade like a stock, you also have the flexibility of short-selling an ETF if you are looking to do so.
Trading verdict – With ETF units trading like regular stocks throughout the regular trading day, ETFs are generally easier to trade and offer investors more flexibility, making them the superior fund structure in this category.
Our Final Verdict
Although both mutual funds and ETFs are good ways to access pooled investments, ETFs are generally the superior option out of the two due to their lower average fees, trading flexibility, and tax efficiency.
Although ETFs come out on top, there are certain situations in which you may want to consider investing in mutual funds instead.
Consider investing in ETFs if:
- You are investing for the long term and are not concerned with short-term fund fluctuations
- You do not meet the minimum investment requirement that some mutual funds have
- You are concerned with tax efficiency, especially in non-registered accounts
Consider investing in mutual funds if:
- You have found a mutual fund that has managed to outperform its benchmark consistently net of fees
- You are looking for some degree of downside protection (that is sometimes offered by active management)
- You are not concerned with tax efficiency
ETFs and mutual funds remain options to consider if you are looking to diversify your portfolio but do not want to spend time researching or trading individual investment securities.
If you are new to investing, make sure to check out my 20 tips on investing for beginners in Canada.