The exchange-traded fund (ETF) structure shares certain similarities with mutual funds, but also important differences that investors need to understand, especially if you’re used to investing through mutual funds. These differences can prove to be advantageous for investors in actively managed ETFs compared to other investors who hold their money in active mutual funds.
Investing in Active ETFs vs Mutual Funds: A Brief History
When the first mutual funds appeared on the scene in the 1920s and subsequently exploded in their numbers in the 1950s and 1960s, most investors utilized these funds to access actively-managed portfolios.
That largely held true until the first retail index mutual fund was launched by John Bogle in 1976, the same fund that is now the Vanguard 500 Index Fund. Since that time, passive index funds proliferated both in traditional mutual fund and ETF vehicles, resulting in the tremendous growth of assets in passively managed strategies fueled partly by redemptions from actively managed mutual funds.
Until fairly recently, investors looking for active management of their money could only look to mutual funds. However, with the launch of actively-managed exchange-traded funds (ETFs) in the US in 2008, investors looking for active management gained the option of investing through ETFs, an option that passive investors have long enjoyed.
Active ETFs vs Mutual Funds: Similarities and Differences
Active ETFs combine the potential benefits of active management traditionally offered through mutual funds with the lower cost and tax-efficiency of ETFs, popularized in recent years primarily through passive ETFs.
This table provides a comparison of active ETFs vs active mutual funds, as well as to passive ETFs:
Active Mutual Funds
Seeks to outperform the market or its benchmark
Relies on the active security selection of a fund manager
Tracks an index or popular benchmark
Trades on one or more stock exchanges
Can be sold short
Can be purchased on margin
Relative cost (typical)
Let’s take a further look at the primary distinguishing factors between actively-managed ETFs and active mutual funds.
- Transparency Requirements
- Tax Efficiency
- Intraday Pricing and Liquidity
- Lower Expenses
- No Investment Minimums or Sales Loads
1. Transparency Requirements
The first fundamental difference between Active ETFs and active mutual funds historically has been the level of transparency.
Most mutual funds in the US report their holdings to shareholders only on a quarterly basis. This means that in between reporting periods, investors with money in an active mutual fund have little idea about what their fund is holding. The quarterly reporting also makes style drift harder to detect for investors.
For instance, in between quarterly reporting periods, portfolio managers could well make more aggressive investments in an effort to generate return and take on more risk than investors would expect based on the fund’s investment mandate.
And just prior to the period end, managers would reign in their bets and bring their portfolio back within stated limits by reporting time – a phenomenon commonly known as “window dressing”, where portfolio managers bring their portfolios back into a good shape that investors will be happy with just prior to the reporting date.
In contrast, the Securities and Exchange Commission (SEC) has historically treated actively-managed ETFs in the US just like any other ETF and required the fund to provide daily disclosure of all holdings as of the last business day on their website.
For example, for PIMCO’s Enhanced Short Maturity Fund, one of the largest actively-managed ETFs, you can find a listing of every single one of the fixed-income securities that MINT holds. Such extensive disclosure ensures the accountability of the portfolio managers to a much higher degree than in active mutual funds.
However, on November 14, 2019, the Securities and Exchange Commission (SEC) publicly announced its intention to approve new ETF structures allowing actively-managed ETFs to not publish their holdings each day. These new types of ETFs are commonly referred to as semi-transparent ETFs or non-transparent ETFs.
2. Tax Efficiency
When invested in active mutual funds, investors have to suffer tax consequences due to the actions of other investors in the fund, even though they have nothing to do with those actions.
This inequity results from the structure of mutual funds. When any one investor decides to sell out of a mutual fund, the fund manager has to raise cash by selling some securities if he/she was fully invested previously. The sale of those securities can result in realized capital gains that get taxed and the tax bill is footed by all investors in the fund, even those who did not sell any shares.
In 2008, investors felt the full brunt of this inequity as they suffered large losses in their mutual fund holdings with equity markets crashing but still received tax bills at year end due to numerous investors pulling out of mutual funds all together.
In contrast, with Active ETFs, an investor’s tax consequences are only affected by their own actions. The exchange-traded nature of these funds means that investors can buy and sell shares in the secondary market just like stocks.
The exchange-traded nature of these funds means that investors can buy and sell shares in the secondary market just like stocks.
Hence, the portfolio manager does not have to raise cash for small redemptions, when the secondary market liquidity is sufficient to meet the sell orders. Even in situations where there are large orders, market makers can create or redeem “creation units” in exchange for a basket of securities held by the portfolio. This in-kind creation or redemption process again avoids the sale of securities and hence capital gains taxation.
3. Intraday Pricing and Liquidity
When you are looking to get in or out of an active mutual fund, you can do so only at one point in the day, at 4pm ET and at a price that you will not be aware of until after the fact. One advantage of this mechanism is that investors can be assured that there shares will be transacted at the fund’s net asset value (NAV). However, the investors cannot know this NAV before hand and also does not know what the fund’s NAV is intraday with mutual funds just releasing the closing NAV on market close.
Actively-managed ETFs differ significantly in this aspect because they are exchange-traded, just like stocks. This means you can see the indicative value for an Active ETF at any point in the day, just as you would for a stock.
However, notice that I said “indicative value” and not the NAV. Because an Active ETF trades on the secondary market, its share price can differ from the fund’s true NAV. However, the market maker or designated broker has an incentive to keep the deviation of the share price from the NAV to a minimum because they can arbitrage between the share price and the fund NAV, in the process reducing that deviation.
Being exchange-traded, investors can get in and out of a fund at any point when the market is open, they see the rough price of the fund at any point, and also have the ability to use limit prices, margin or even short the fund just as they would for any stock.
4. Lower Expenses
Most actively-managed ETFs have expense ratios that are lower than those on the average active mutual fund that provides investors with exposure to a similar strategy. This is because, operationally, ETFs are cheaper to run than are mutual funds and the fund administration process is simpler. ETFs don’t really need large shareholder servicing departments that mutual funds have.
Another important factor that leads to lower costs is that ETFs do not pay trailer fees to investment advisors who recommend them to investors. For mutual funds, traditional investment advisors could receive a trailer fee up to 1% which gets added on to the total expense ratio (TER), the headline expense that investors see. As a result, Active ETFs on average end up being cheaper for investors relative to comparative strategies in active mutual funds.
5. No Investment Minimums or Sales Loads
A final major difference is that most active mutual funds have minimum investment amounts to enter the fund usually between $1,000 – $5,000 for retail funds. In contrast, Active ETFs have no minimum whatsoever, as long as you have enough money to purchase a single share of the fund on the market.
Active mutual funds can also charge sales loads which may be front-end or back-end, usually ranging anywhere from 1% – 5%. These loads also reduce the actual investor capital that ends up being invested or redeemed from the fund.
Balancing out that advantage historically was the brokerage commission charge that investors would have to pay when purchasing an Active ETF through their discount brokerage. But since the largest discount brokerage firms led by Charles Schwab eliminated commission charges in 2019, this likely will not be an issue for you if you are a do it yourself (DIY) investor.
Disclaimer: This article is intended for informational purposes only, and should not be considered financial advice. Before making major financial decisions, please speak with us or another qualified professional for guidance. The original version of this article first appeared on Wealthtender written by Shishir Nigam.