Mutual Funds vs. ETFs | Finances | MD&D #36

Evidence based insights into physician compensation, RVUs, contracts, healthcare economics, and personal finances. For residents, fellows, and early-career attendings.

Life and Finances, in Medicine.

When you begin to invest, you often hear two terms: Mutual Funds and Exchange-Traded Funds or ETFs. Many assume that these two terms represent completely different kinds of investments. But the truth is both are in the same general category, they are both funds, and more importantly, both can own the exact same investments!

1st TextWhat is the difference then? The difference is not what you own. The difference is how you own it and how you trade it.

Same Investments, Different Structure

Imagine you want to invest in the S&P 500, the index that represents about 500 of the largest companies in the United States, publicly trading in the stock market. Then, you find two options:

Both track the same index and hold stocks from the same companies, like Apple, Microsoft, or Amazon. So, how do you choose which one is best for you? One of the differences is how ETFs and mutual funds trade.

With a mutual fund, you buy or sell shares through a fund company, not on the stock market. And the price of the stock is calculated once a day only, after the market closes.

With ETFs, you buy or sell shares on the stock market, just like any individual stocks. That means its price fluctuates throughout the day.

This difference matters if you are an active investor and you want control over when and at what price you want buy or sell. You can react immediately to market movements. This is not the case with Mutual Funds. You can place an order to buy or sell shares at any time of the day, but the transaction won’t be executed until the end of the day, when the market closes using what is called the day's NAV, or Net Asset Value.

If you are a passive, long term investor, building wealth over decades, this difference in trading between mutual funds and ETFs is not very important, honestly.

Are there any difference on diversification?

Diversification depends on what stocks the fund owns. That’s it. Whether the fund is an ETF or mutual fund makes no difference. Both can hold the same stocks. So, both can be equally diversified or equally concentrated. Many people believe the word ETF automatically means diversified, or better than mutual funds. That is a misconception. It all matters on the stocks held inside each of these funds. Same stocks? No difference then.

Are there differences in investment costs?

Most ETFs usually have very low expense ratios. But some index mutual funds may be just as cheap. Costs can be different based on management style. Some actively managed ETFs are expensive, while some index mutual funds are extremely cheap. So, if there is a difference in costs between one and the other, it is related to the stocks that they hold, as much as to how the fund is managed, its expenses, and the investment strategy you chose, not simply because one is an ETF and the other one a mutual fund.

Do they have different Returns?

Not really. We already established that both, an ETF and a mutual fund track the same stock index, with similar expenses, it’s expected that their performance would be very similar. Assuming their investment costs and tracking accuracy are similar too. But just like with investment costs, the most important thing for your returns is the stock that you own inside the fund.

Do they have different Tax treatments?

If you have a taxable brokerage account, ETFs have a tax-efficiency advantage when they are in a taxable brokerage account, because their structure allows them to avoid many of the taxable capital gains distributions that mutual funds may generate. ETFs distribute fewer capital gains than mutual funds. So, they don’t trigger capital gain taxes for those fewer capital gains distributions. But this advantage occurs in taxable brokerage accounts. In retirement accounts like a 401(k), Roth IRA or traditional IRA that advantage disappears, because these are tax deferred accounts.

Mutual funds work in a different way. Again, imagine you own shares of a mutual fund that holds stocks of big companies like Apple, or Microsoft. Then, a bunch of big investors decide to withdraw their money. If the fund doesn't have enough cash available, it will need to sell some of its stocks to pay those investors. If those stocks have appreciated, then the sales generate capital gains that may eventually be distributed to the remaining investors. That means you. So, you could owe taxes even though you personally never sold any of your shares of that mutual fund.

This is the structural tax advantage of ETFs.

What happens when you sell your own ETF shares?

There is another important distinction: when you sell ETF shares, you sell them to another investor on the stock exchange. The ETF itself doesn't need to sell its underlying stocks to pay you, like it might happen with mutual funds if it doesn’t have enough cash available.

In mutual funds you sell them back to the mutual fund company, which pays you the NAV of that end of the day.

Think of ETFs and mutual funds like hardcopy and paperback copies of the same book. The content is the same, but each option has certain benefits for investors.  So, before you ask yourself if you should buy an ETF or a mutual fund, ask yourself a more important question: What do I want to invest in? Once you have answered that question, compare available funds based on their expense ratios, tax efficiency, trading history and investment minimums. Then choose based on these values. Basically, you are judging the book by its content, not by its cover.

1.        ETFs and mutual funds can hold the same stocks.

2.        There are no inherent differences in investment costs or returns between them

3.        ETFs and mutual funds differ in how they trade and in their tax treatment. This last one is only relevant in brokerage accounts, not retirement accounts.

The investments in a fund determine its returns, not if the fund is an ETF or mutual fund.

Have a question about compensation, contracts, personal finance, or life decisions in medicine? Send it to MD&D. Your question may be answered in a future article, podcast, or Q&A.

email: [email protected]

MD&D is a FREE platform for residents, fellows, and early-career attendings who want to better understand RVUs, compensation, contracts, and finances in medicine.
Website:
mddecisions.org

Newsletter:
read.mddecisions.org

Free RVU Playbook:
playbook.mddecisions.org

Join a growing community of medical professionals dedicated to understanding the business of medicine.

Bruno Casanova, MD

Founder & Host

MD&D: Medicine, Dollars & Decisions

Life and Finances, in Medicine.

mddecisions.org