ETF

ETF Vs Mutual Fund: What it means for your investment portfolio?

Imagine a fund with three stocks; Microsoft, Apple and Amazon.

The fund can be structured into different types of financial vehicles that contain the same three stocks. Now imagine yourself sitting in an actual vehicle (say a BMW). You are the stock and the BMW is the financial vehicle. Similarly, instead of a BMW, you could be sitting in a Mercedes. Simply put, the Mercedes and the BMW are the different types of financial vehicles that contain the stock (you).

While there are numerous types of financial vehicles, we would be looking at ETFs and mutual funds exclusively in this article since these two types of financial vehicles are the most common types of investment vehicle that most retail investors in Singapore would have access to.

Mutual Funds

Mutual funds are perhaps the oldest type of financial vehicle. It is an investment fund that pools money from many investors to purchase and sell asset securities. Most mutual funds are actively managed by hired professional fund managers though there are index mutual funds (passively managed) as well. Mutual funds can be further broken down into either open-ended funds or closed-ended funds.

Open-ended Funds

An open-ended fund is a fund that can issue an unlimited number of shares. In the event of subscriptions (buy) and the redemptions (sell) of the shares, the fund sponsors would buy/sell to the investors directly. Open-ended fund shares are not traded on an exchange. Instead, the fund prices are priced once a day at the end of the trading day by using the end-of-day prices of all the securities’ prices in the fund. The price of a single fund share is then calculated by taking the NAV and divided by the number of outstanding shares issued.

Net asset value (NAV) = Market value of all asset securities – Fund’s liabilities

Unit trust (UT) is an example of an open-ended fund and is the most common type of investment vehicle in Singapore.

Closed-ended Funds

Unlike open-ended funds, closed-ended fund shares are traded on an exchange after its initial public offering (IPO). Since the fund shares are traded on an exchange, closed-ended funds shares tend to offer more liquidity than open-ended funds shares. However since the funds are traded on an exchange, buying and selling of the fund shares may impose additional charges related to the trading costs on an exchange such as bid-ask spread, fluctuating premium/discount to the NAV, etc.

An open-ended fund can be restructured into a closed-ended fund. This usually happens when the asset under management (AUM) of the fund gets too big for the fund to execute its investment objective effectively.

ETF

ETF stands for Exchange Traded Fund. Similar to a stock listed and traded on the stock exchange, ETFs are also listed and traded on a stock exchange. Unlike mutual funds, most ETFs are passively managed, i.e. they are index funds. Though, the number of actively managed ETFs are on the rise.

ETF has an ‘unique’ fund structure. It is positioned between open-ended and closed-ended funds. It is an open-ended fund in the sense that it can issue unlimited shares, and at the same time, it is traded on a stock exchange like a closed-ended fund.

ETFs can either be passively or actively managed. Same goes for mutual funds.

Now, you may ask yourself; which is a better structure? While there may be no definitive answer, I do believe that ETF may be the more ‘optimal’ fund structure. My arguments are laid out below.

ETF is cheaper than Mutual Fund

Since most ETFs are passively managed, ETFs tend to have lower Total Expense Ratio (TER) than actively managed mutual fund. I know, not exactly an apple-to-apple comparison. Luckily for me, ETF.COM has the necessary statistic.

Total Expense Ratio (TER) is the total operating cost of managing a fund from the fund house’s perspective, which includes management fee, custodian charges, trading cost, administrative fees, operational expenses, etc. TER does not take into account of your transaction cost of buying/selling of the funds and your financial advisor’s fees.

The average TER of an actively managed US-listed ETF is 0.65% whereas the average TER of an actively managed mutual fund in the United States is around 1%. In Singapore, fees are even higher, where the average TER for an actively managed US-focused mutual fund exceeds 1.8%. Imagine the horror on my face when I found out about this. In this day and age, no one should be paying more than 1% for an active fund.

The implication of a high TER is that it diminishes the fund’s net return and in turn, further reduces the actual return that the investor receives after accounting for taxes and transaction costs. Gross return is the total return of the fund that has NOT being accounted for all the associated cost of running the fund, ie TER.

Net Return = Gross Return – Total Expense Ratio

Investor’s Actual Return = Net Return – Transaction Cost and/or Taxes

An investor’s actual return is the nominal return that goes into the investor’s pocket after the investor closed the position, not accounting for inflation. While investors have no control over the gross return of a fund, they certainly have control over which fund they choose to invest. All things equal, choose a fund with a lower TER.

For more information on the TER in the US, see https://www.etf.com/channels/active-management-etfs

For more information on the TER in Singapore, see https://www.businesstimes.com.sg/opinion/high-fund-expense-ratios-put-singapore-retail-investors-in-a-bind

ETFs are more tax-efficient than Mutual Funds

ETFs and mutual funds have different fund structures and therefore have different tax regulations pertaining to its fund operations.

By design and all things equal, a mutual fund would generate more capital-gain transactions than an ETF. When a mutual fund investor sell their fund, in order to raise cash for the investor (assuming that the fund is fully invested), the fund manager would need to sell the underlying securities in the fund. This would result in a capital gain tax bill. Depending on your country of residence, this tax bill would affect you differently.

In Singapore, the capital gain tax rate is 0%. Hooray!!!

When an ETF investor sells his/her ETF, the ETF itself is transferred to another investor/AP. There is no underlying security transaction taking place as a result of this transfer and therefore no capital gain tax bill.

This is simply because no underlying securities in the ETF are being sold. It is the ETF which contain the underlying securities, that got bought/sold, not the underlying securities itself.

Market makers are financial institutions that provide bid and offer quotes in the market to ensure that the buying and selling of securities take place.

Authorised Participants (AP) are the market makers for the ETFs’ issuers. When an ETF issuer wants to create new units/shares. The AP would be responsible for acquiring the underlying securities to create the new ETF units.

Not all market makers are AP but all AP are market makers.

When there is an excess supply of an ETF’s units in the market with no buyer, AP would usually buy up the excess units. With units of ETFs in its holdings, the AP would want to redeem the units from the ETF issuers.

When the AP redeems its units, the ETF issuer would first pay the AP “in-kind” by simply delivering the underlying securities in the ETF itself. Once again, this does not generate any capital gain tax because there is no transaction taking place (according to the US regulation).

ETFs are more transparent than Mutual Funds

Unlike most mutual funds that display their full holdings on a quarterly basis with a 30-day lag (that is, for the first quarter holdings, the fund would disclose the full holdings at around April), most ETF issuers disclose their funds’ full holdings on a daily basis, while some do it on a monthly basis (I am looking at you, Vanguard! Not a deal-breaker though, still an awesome company with great investment offerings).

Knowing what is under the hood of your investment fund makes you a more informed investor and in turn, helps you become a better investor overall.

Liquidity

Unlike mutual funds where the fund house would collate the subscription/redemption orders at the end of the day and proceed to buy/sell the securities on the next trading session, you can buy/sell ETFs in the middle of the trading session since ETFs are listed on the stock exchange.

Note that not all ETFs are highly liquid in the market. Some exotic products such as triple leverage ETFs can be illiquid especially in market distress. But most of the ETFs that should form the core of an investor’s portfolio are highly liquid ETFs.

Liquidity is the ease of conversion from your securities into cash and vice versa. In general, the higher trading volume would translate to higher liquidity. In illiquid markets/products where there are limited buyers/sellers, AP/market makers are there to provide liquidity. Market makers are there to buy when no one is buying and sell when no one is selling.

If you are not disciplined enough, this can be a double-edged sword. In the event of a huge market downturn, having instant access to the market might result in you acting impulsively and to sell off your position when the rational decision is to buy more. I will elaborate on investors’ psychology and the optimal strategy in a market downturn in a separate article.

Conclusion

To conclude, I have included a table below for a comparison summary.

ETF Mutual Fund
Structure In between open-ended and closed-ended Can either be open-ended or closed-ended fund
Traded on the stock exchange? Yes Open-ended fund: No (Very prevalent in Singapore)
Closed-end fund: Yes
Total Expense Ratio Lower Higher
Display full holdings frequency Most disclose daily with some discloses monthly Quarterly basis with a 30-day lag
Liquidity Higher Lower
Tax efficiency More efficient Less efficient
Active or Passive Can be both. Mostly passive. Can be both. Mostly active.

As always, take personal responsibility in your financial well-being and do your own due diligence.

 

 

Disclaimer: This article does not constitute a solicitation to buy/sell any securities that may be mentioned in this article. At the time of writing and publication, the author does not hold any position in any of the securities mentioned in this article. I am writing in my personal capacity and my views do not represent that of any organisations.  

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