Editor: Mohamad Sawwaf
You’re probably familiar with mutual funds. Most people have encountered them at some point — either through their banks and financial advisors. ETFs however, are a newer investment, which people tend to associate with lower fees, broader diversification, and greater transparency.
It has been argued that the benefit of mutual funds was its active management mandate whereby the fund manager was expected to outperform its benchmark index. The major factor here was that with active management came higher trading costs and these higher trading costs translated into higher Management Expense Ratio (MER) and fund manager would find themselves behind their benchmark starting on January 1 of every year by up to 2.35%.
With ETFs, they were based on a passive management strategy because the theory is that it is very difficult to outperform the index so why not just mimic it? This in effect meant lower trading costs, lower overhead and hence a more competitive MER.
So, what is the difference between a Mutual Fund and an ETF?
Let’s look at these three key factors that separate these two investment products.
The average management expense ratio (MER) you can expect to pay in North America for equity mutual funds is 0.84% to 2.35%. Compare this with the average MER for an ETF, you can expect to pay between 0.24% to 0.56% depending on whether you are investing in a Fixed Income or Equity ETF.
To put this in perspective, if you have an investment portfolio of $100,000, you could be paying upto $2,350 to fees every year on average whereas with the same portfolio amount invested in ETFs you could be paying up to $560 to fees every year. An annual savings of $1,790. This could amount to hundreds of thousands of dollars lost in your investment account over a lifetime.
Mutual funds are bundles of stocks and bonds that are managed for you by a bank or investment firm. Traditionally, they’re taking a hands-on approach to try to beat the market.
With actively managed mutual funds, you have managers who are trading a lot to take advantage of opportunities. However, this active trading comes at a cost, which usually translates into higher fees.
Most ETFs tend to take a different approach. They were primarily set up to track a broad based index of investments like the TSX or the Dow Jones Industrial Average or an industry specific index like the Nasdaq.
By investing in an ETF, you also have transparency into the individual holdings. Most Mutual Funds show their top 10 holdings and even though you may be investing in a North American “Equity Mutual Fund”, this doesn’t stop the fund manager from investing into stocks that are outside of North America. Alternatively, if an ETF is tracking a certain index, it is tracking that index exclusively.
Considering that you can create a similarly diversified portfolio at a lower cost with greater transparency into the underlying holdings, ETFs may be the answer of choice for you as an investor.
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Investing in securities involves risk, and there is always the potential of losing money when you invest in securities.
Halal compliant investments, diversification and asset allocation do not ensure a profit or protect against loss.
This material is intended for informational purposes only and should not be construed as legal or tax advice, nor is it intended to replace the advice of a qualified attorney or tax advisor.