The first assertion to explore is that exchange-traded funds (ETFs) always track a market index through index or passive management, while mutual funds (MFs) are managed actively. This misconception has led to a great deal of misunderstandings when comparing these investment vehicles.
Here is some important information to better understand the nature of ETFs and their differences and similarities with MFs. Present in the economic landscape for several years, ETFs are now well-established and deserve that we examine their characteristics and bust certain myths that have persisted over the years.
What is an ETF?
An exchange-traded fund (ETF) is an investment fund whose units are traded on a stock exchange like any regular stock1. Much like mutual funds (MFs), ETFs are legal entities, “containers” that can hold anything, as long as the liquidity of the instruments added (e.g. stocks, bonds, derivatives, ETFs, MFs, etc.) is kept above a minimum threshold, and they can be managed through various investment strategies.
ETFs vs MFs
Despite their similarities, ETFs and MFs differ in many ways. Here are some of their key features for a better comparison.
MFs and ETFs can both be managed using an active or passive (index) portfolio management strategy, which is a strategy that may seek to track the performance of a market index.
Like a regular stock, an ETF can be traded on the stock market during trading hours, while transactions on MFs take place over-the-counter, once a day, after the market closes. This is the key difference between the two vehicles.
A MF trades at a price that reflects the fair value of its underlying assets at market closing. While the value of a MF is only affected by the price of the securities it holds, the price of an ETF is dependent both on the value of the securities it holds and on the law of supply and demand, as the fund is traded like a stock. This price determination factor can lead to a tracking error between the real value of the underlying securities and the value of the ETF. This divergence is usually minimal and insignificant. However, when the difference becomes too important, arbitrage opportunities emerge, and capitalizing on them will bring back the tracking error within a more normal range.
With regard to MFs, advice is either included or tacked on as a supplement through fees. For ETFs, advice is only provided for a fee.
With both vehicles, the cost will depend on the investment strategy that’s been chosen. For example, it is more expensive to manage emerging market stocks than Canadian bonds and active management is costlier than passive management. Whether the MF is offered with or without services will also impact its cost. For an ETF, aside from the type of strategy, the brokerage fees and bid-ask spread will also affect the cost.
Characteristics of ETFs and MFs
|Transactions||On the market, at any time during trading hours||Over-the-counter, once a day, after closing time|
Two determining factors:
> Demand for the ETF
> Value of underlying securities
|One determining factor:
> Value of underlying securities
|Advice||As a supplement, through fees||As a supplement, through fees
> Investment strategy
> Brokerage fees
> LBid-ask spread
> Investment strategy
> Whether the series (A, D, F, O) of the fund is offered with or without services
Source: FÉRIQUE Funds Management
Are costs and returns significantly different?
Of all the differences between ETFs and MFs, the cost is the one most frequently cited. Returns also get people talking. Some investors swear that ETFs perform much better than other funds but how do they really stack up?
Similar costs when compared on the same basis
One of the most common misconceptions is that ETFs cost significantly less than MFs. The truth is that when compared on the same basis, their prices are very similar. Setting side by side the management expense ratios (MER) of the different structures of the funds (with and without services) and comparing the cost of an ETF with that of its equivalent MF shows that these investment vehicles are equivalent. Moreover, an ETF’s brokerage fees and bid-ask spread must also be taken into account when calculating its cost.
Since the same assets can be invested in both MFs and ETFs at similar costs for equivalent strategies, the returns achieved or sought are fairly similar. The relative performance between these two investment vehicles is not at stake when they are compared based on the same parameters.
MF or ETF, which one is better, then?
The costs and returns discrepancies between ETFs and MFs are directly tied to the underlying investment approach chosen (whether active or passive) and the type of distribution method preferred by the fund company (with or without services).
If ETFs and MFs are two vehicles providing the same products at a similar cost, the question remains: why did the financial industry create ETFs as an alternative to MFs?
The answer is that it allows fund companies to offer an investment vehicle suited to different distribution models and distribute more broadly their products.
For example, FÉRIQUE Fund Management products are distributed to clients through FÉRIQUE Investment Services (a mutual fund broker). Meanwhile, in other companies, the products may be distributed through branches, discount brokerage or independent brokers.
The licences required to provide advice related to ETFs and MFs are different in all the above situations.
Offering MFs or ETFs is normal and legitimate and in line with fund companies’ distribution strategies.
Source: FÉRIQUE Funds Management
A matter of choice
As we can see, ETFs and MFs have a lot in common, and the discrepancies with regard to costs and returns stem from the choices investors make. When deciding which investment vehicle suits you best, it is important to compare them based on the same parameters, such as advice provided and management strategy. These parameters may have an impact on the cost and performance of your investments.
Providing advice, an integral part of FÉRIQUE Fund Management’s business model!
As a fund company, FÉRIQUE Fund Management offers MFs, since we favour a business model that includes the provision of advice and only distribute our products through FÉRIQUE Investment Services. Thanks to our non-profit status that allows us to return benefits to our clients, FÉRIQUE Fund Management offers mutual funds with some of the lowest MER of the industry in Canada2, while still including services.
For us, accelerating financial autonomy means serving our clients. This approach promotes better saving behaviours and prevents impulsive decisions.
1. Source: Autorité des marchés financiers
2. Compared to their reference universe in Canada, according to Fundata Canada Inc.
This review has been prepared for the general information of our clients and does not constitute an offer or solicitation to buy or sell any securities, products or services and should not be construed as specific investment advice. All opinions and estimates expressed in this document are as of the time of its publication and are subject to change. The information contained in this document has been obtained from sources believed to be reliable, but we do not represent that it is accurate or complete and it should not be relied upon as such. The content of this presentation is the exclusive property of Gestion FÉRIQUE and should not be further distributed without prior consent of Gestion FÉRIQUE.
Mutual funds: Mutual funds pool money from investors, which is then invested by a manager in different types of investment vehicles based on the fund’s objectives. In exchange for their money, investors in a fund receive units that give them an ownership right to a portion of the mutual fund.
Passive or index management: Passive or index management seeks to track the performance of a benchmark market.
Active management: Active management seeks to outperform the managed portfolio’s benchmark market.
Tracking error: A tracking error is the standard deviation between the returns of a portfolio and those of its benchmark index.
Arbitrage opportunities: Financial operations that seek to ensure zero or positive gain by taking advantage of temporary price discrepancies between different securities or contracts.
Brokerage fees: Brokerage fees refer to the fees charged by a financial organization acting as a broker when establishing a relationship, concluding a transaction or providing services.
Bid-ask spread: Difference between the bid price and ask price of an asset on the market. This spread allows the market maker to get paid and indicates the liquidity of a security (the larger the spread, the less liquid a stock will be).
Series A: Funds series with advisory services - This series or class of a fund is offered with advice.
Series F: Load series - This series or class of a fund is offered to investors who have entered into a fee payment agreement with their advisor.
Series O: No-load series – This series requires a high minimum investment and is offered to individuals and institutional investors, as well as brokers who have concluded a security purchase agreement with the fund company. Series O unitholders pay the negotiated fees directly or indirectly to the fund company.
Series D: Reduced-load series – This series or class is suitable for independent investors who purchase funds through discount brokers. When they sell series D units of a fund, these brokers usually earn a very low trailing commission, because the investor receives no advice.
Mutual fund broker: A broker is a professional who manages transactions between his clients and financial institutions, insurance companies or the stock market. Companies or brokers involved in legal transactions with regard to mutual funds are registered as mutual fund brokers.
Discount brokerage: Discount brokerage firms are similar to mutual fund brokers, but they don’t provide advice.
Independent broker: Independent brokers are self-employed. They are not associated with a single bank or financial institution.