ETFs and mutual funds are similar in that they both allow you to invest in a basket of securities with one purchase. They both can be held in registered or non-registered accounts, and they both offer variations to suit your risk profile and investment goals. However, there are also some key differences between them that you should consider before investing.
ETFs trade on stock exchanges like stocks do, which means you can buy and sell them throughout the day at the market price. You’ll also need to pay a commission fee to your broker for each trade. Mutual funds are only priced and traded once a day at the end of the day, based on their net asset value (NAV). Another difference is how they are managed. ETFs are typically passively managed while mutual funds can be either actively or passively managed. ETFs are also generally more tax-efficient than mutual funds because they have lower turnover rates and fewer distributions.
As you can see, ETFs and mutual funds have their own advantages and disadvantages that depend on various factors such as your investment style, time horizon, risk tolerance, and tax situation. There is no definitive answer as to which one is better for you, but rather it depends on your personal preferences and goals. You may also choose to invest in both types of products to diversify your portfolio further and benefit from their unique features. The important thing is to do your research, compare your options, and make informed decisions that suit your needs.
If you’re looking for a way to invest your money in the Canadian market, you might be wondering whether you should choose an exchange-traded fund (ETF) or a mutual fund. Both are popular types of investment products that can help you diversify your portfolio and achieve your financial goals. But what are the differences between them, and which one is right for you?
In this blog post, we’ll explain what ETFs and mutual funds are, how they work, and what are their pros and cons. We’ll also compare them on various aspects, such as fees, performance, tax efficiency, and risk. Finally, we’ll give you some tips on how to decide which one suits your investing style and needs.
What Is An Exchange-Traded Fund (ETF)?
An ETF, or exchange-traded fund, is a type of investment product that allows you to buy or sell a collection of securities, such as stocks, bonds, or commodities, on a stock exchange. An ETF can give you exposure to a specific market, sector, industry, or strategy, with the convenience and flexibility of trading like a stock.
ETFs work by pooling the money of many investors and using it to buy a basket of securities that follows a certain index, benchmark, or theme. For example, an ETF that tracks the S&P 500 Index will hold the same stocks as the index in the same proportion. An ETF that focuses on technology will hold stocks of various technology companies, and a gold ETF invests in physical gold or gold-related securities.
An ETF has a share price that changes throughout the day based on supply and demand. You can buy or sell your ETF shares at any time during the trading hours at the market price, which may be different from the net asset value (NAV) of the underlying securities. The NAV is calculated at the end of each trading day based on the closing prices of the underlying securities.
Pros Of ETFs
More Affordable Fees
While some ETFs can be actively managed, most ETFs are passively managed and only reflect the value of the underlying index they’re built to track. Because of this, one of the main advantages of ETFs is their low cost in terms of lower management fees and operating expenses. This means that you get to keep more of your returns and pay less to the fund provider. For example, the average management expense ratio (MER) for Canadian equity ETFs was 0.61% in 2020, while the average MER for Canadian equity mutual funds was 2.06% that year.
Fewer Distributions And Better Tax Efficiency
Another benefit of ETFs is their tax efficiency. ETFs rarely distribute capital gains to their investors. This means that you don’t have to pay taxes on those gains until you sell your ETF shares, and you avoid paying income tax every year because of those distributions. This can help you defer taxes and reduce your tax bill in the long run, making ETFs a more tax efficient investment option.
Trading Flexibility
A third advantage of ETFs is their trading flexibility. ETFs can be bought and sold throughout the day at the market price, which changes depending on supply and demand. This gives you more control over when and how much you pay for your ETF shares. You can also use different types of orders, such as limit orders or stop-loss orders, to execute your trades according to your preferences. You can also sell your ETF shares short or buy them on margin if you want to enhance your returns or hedge your risks.
Cons Of ETFs
Commission Charges
One of the main drawbacks of ETFs is their commission charges. Unlike mutual funds, which are sold based on dollars, ETFs are sold based on shares. This means that every time you buy or sell an ETF share, you have to pay a commission fee to your broker. Depending on how often you trade and how much you trade, these fees can add up and eat into your returns.
Bid-Ask Spread
Another disadvantage of ETFs is their bid-ask spread. The bid-ask spread is the difference between the highest price that a buyer is willing to pay for an ETF share (the bid) and the lowest price that a seller is willing to accept for an ETF share (the ask). The wider the bid-ask spread, the more it costs you to trade an ETF share. The bid-ask spread depends on various factors, such as the liquidity, volatility, and popularity of the ETF. Generally speaking, the more niche or specialized an ETF is, the higher its bid-ask spread will be.
Tracking Error
A third drawback of ETFs is their tracking error. Tracking error is the difference between the performance of an ETF and the performance of its underlying index or benchmark. The higher the tracking error, the more an ETF deviates from its expected return. Tracking error can be caused by various factors, such as fees, rebalancing frequency, sampling methods, market conditions, and currency fluctuations. Generally speaking, the more complex or diversified an ETF is, the higher its tracking error will be.
What Is A Mutual Fund?
A mutual fund is a type of investment product that allows you to pool your money with other investors and buy a collection of securities, such as stocks, bonds, different types of real estate (including farmland), cryptos (Bitcoin ETFs, Ethereum ETFs) or other assets, from a fund provider.
Mutual funds can be both actively or passively managed. Mutual funds are managed by a professional fund manager or a team of professional managers who decide what securities to buy and sell for the fund based on its investment objectives and strategies. These managers take care of all due diligence regarding each asset they invest in on behalf of the investors so you don’t have to.
Actively managed mutual funds seek to outperform the market or a specific benchmark by using research, analysis, and judgment. For example, an actively managed mutual fund that invests in Canadian stocks may try to beat the performance of the S&P/TSX Composite Index by picking the best stocks in the Canadian market.
Passively managed mutual funds are more similar to ETFs in that they follow the performance of a specific market index or benchmark. The goal of a passively managed mutual fund is to match the market or a specific benchmark by holding the same securities as the index or benchmark in the same proportion, so there’s no need to do any research to choose which assets to invest in.
Pros Of Mutual Funds
Professional Management
One of the main advantages of mutual funds is their professional management. Mutual funds are run by fund managers who research, pick, and monitor the performance of the underlying investments. This means that you don’t have to worry about choosing or managing your own investments or doing due diligence, and you can benefit from the expertise and experience of the fund managers. For example, if you invest in an actively managed mutual fund, the fund manager will try to beat the market by selecting the best stocks or bonds for the fund.
Diversification
Another benefit of mutual funds is their diversification. Mutual funds allow you to invest in a large number of different companies, industries, sectors, countries, or regions with a relatively small amount of money, since you’re not actually buying the shares themselves but a fraction of them proportional to your investment in the fund. This can help you reduce your exposure to risk and increase your potential returns by spreading your money across various investments. For example, if you invest in a balanced mutual fund, the fund will allocate your money between stocks and bonds according to a predetermined ratio.
Convenience
A third advantage of mutual funds is their convenience. Mutual funds are easy to buy and sell, as you only need to deal with the fund provider or your financial advisor. You don’t have to worry about finding a broker, paying commissions, or tracking market prices. Also, you can set up automatic contributions or withdrawals from your bank account to your mutual fund account, making it easier to save and invest regularly. You can also switch between different mutual funds within the same fund family without paying any fees or taxes.
Cons Of Mutual Funds
High Fees
One of the main drawbacks of mutual funds is their high fees. Mutual funds charge various types of fees and expenses to cover their operating costs and compensate their fund managers. These fees and expenses can reduce your returns and eat into your investment over time. For example, the average management expense ratio (MER) for Canadian equity mutual funds was 2.06% in 2020, while the average MER for Canadian equity ETFs was 0.61%. This means that if you invest $10,000 in a mutual fund with a 2.06% MER for 10 years, you’ll pay over $2,000 in fees.
Tax Inefficiency
Another disadvantage of mutual funds is their tax inefficiency. Mutual funds often distribute capital gains to their investors at the end of the year. This means that you have to pay taxes on those gains even if you don’t sell your mutual fund shares. This can increase your tax bill and reduce your after-tax returns.
Trading Limitations
A third drawback of mutual funds is their trading limitations. Mutual funds trade once a day at the end of the trading day. This means that you can’t buy or sell your mutual fund shares at any time during the day, and you have to wait until the next day to get the price for your transaction. This can limit your control over when and how much you pay for your mutual fund shares. You also can’t use different types of orders, such as limit orders or stop-loss orders, to execute your trades according to your preferences. You also can’t sell your mutual fund shares short or buy them on margin if you want to enhance your returns or hedge your risks.
Similarities Between ETFs And Mutual Funds
#1 Both Are Pooled Investments
One similarity between ETFs and mutual funds is that they are both pooled investments. This means that they both allow investors to pool their money together and buy a basket of investments that are managed by a fund provider. This can help investors diversify their portfolio and access various markets and sectors with a relatively small amount of money.
#2 Both Can Be Actively Or Passively Managed
Another similarity between ETFs and mutual funds is that they can both be actively or passively managed. Active management means that the fund manager tries to beat the market by selecting the best investments for the fund based on research and analysis. Passive management means that the fund manager tries to match the market by following an index or benchmark that represents a specific market or sector. That said, ETFs are usually passively managed and most high-performing mutual funds are actively managed.
#3 Both Have Different Types And Styles
A third similarity between ETFs and mutual funds is that they both have different types and styles that cater to different investors’ preferences and needs. Some examples of different types and styles of ETFs and mutual funds are:
Equity funds
These funds invest in stocks of companies that trade on the stock market. They can focus on certain market segments (e.g., large-cap, small-cap, growth, value), industries (e.g., technology, health care, energy), or regions (e.g., Canada, U.S., Europe).
Fixed income funds
These funds invest in bonds and other debt securities that pay a fixed or variable interest rate. They can vary in terms of credit quality (e.g., investment grade, high yield, government), duration (e.g., short-term, long-term, intermediate-term), or currency (e.g., Canadian dollar, U.S. dollar, euro).
Balanced Funds
These funds invest in a mix of stocks and bonds to provide both growth and income. They can have different asset allocation strategies (e.g., conservative, moderate, aggressive), depending on the risk tolerance and time horizon of the investors.
Index Funds
These funds track the performance of a specific index or benchmark that represents a market or sector. They can follow broad-based indexes (e.g., S&P/TSX Composite Index, S&P 500 Index) or narrow-based indexes (e.g., S&P/TSX Capped Energy Index, S&P/TSX Capped Financials Index).
Sector Funds
These funds invest in a specific industry or sector that has a common theme or characteristic. They can target sectors that are expected to perform well (e.g., technology, health care, consumer staples) or sectors that are undervalued or overlooked (e.g., utilities, materials, real estate).
Specialty Funds
These funds invest in a niche or emerging area that has a unique opportunity or challenge. They can focus on themes that are relevant to the current or future trends (e.g., environmental, social, and governance (ESG), cryptocurrency, cannabis) or strategies that are unconventional or complex (e.g., hedge fund replication, leveraged, inverse).
Both Can Be Held In The Same Types Of Accounts
One similarity between ETFs and mutual funds is that they can both be held in the same types of accounts, both registered and non-registered. This means that you can choose the account that best suits your investment goals, tax situation, and time horizon. Some of the common types of accounts that you can use to hold ETFs and mutual funds are:
- Tax-Free Savings Account (TFSA).
- Registered Retirement Sa.vings Plan (RRSP).
- Non-registered accounts like normal savings accounts.
Differences Between ETFs And Mutual Funds
#1 Trading Mechanism
One difference between ETFs and mutual funds is their trading mechanism. ETFs trade like stocks on the stock market during normal trading hours. This means that you can buy or sell your ETF shares at any time during the day at the market price, which changes depending on supply and demand. Mutual funds trade once a day at the end of the trading day. This means that you can’t buy or sell your mutual fund shares at any time during the day, and you have to wait until the next day to get the price for your transaction.
#2 Pricing Method
Another difference between ETFs and mutual funds is their pricing method. ETFs are priced based on their net asset value (NAV) per share plus or minus their bid-ask spread. The NAV per share is the total value of the underlying investments divided by the number of shares outstanding. The bid-ask spread is the difference between the highest price that a buyer is willing to pay for an ETF share (the bid) and the lowest price that a seller is willing to accept for an ETF share (the ask). Mutual funds are priced based on their NAV per share only. The NAV per share is calculated at the end of each trading day based on the closing prices of the underlying investments.
#3 Fee Structure
A third difference between ETFs and mutual funds is their fee structure. ETFs have lower fees than mutual funds because they have lower management fees and operating expenses. However, ETFs also have commission charges and bid-ask spreads that can increase your trading costs. Mutual funds have higher fees than ETFs because they have higher management fees and operating expenses. However, mutual funds don’t have commission charges or bid-ask spreads that can affect your trading costs.
Comparison Table For ETFs And Mutual Funds
| Aspect | ETF | Mutual Fund |
| Trading Mechanism | Trades like stocks on the stock market during normal trading hours | Trades once a day at the end of the trading day |
| Pricing Method | NAV per share + bid-ask spread | NAV per share only |
| Fee Structure | Lower fees but higher trading costs | Higher fees but lower trading costs |
| Tax Efficiency | More tax-efficient due to lower capital gains distributions | Less tax-efficient due to higher capital gains distributions |
| Trading Flexibility | More flexible due to ability to use different types of orders and strategies | Less flexible due to inability to use different types of orders and strategies |
| Professional Management | Less active management due to passive nature of most ETFs | More active management due to active nature of most mutual funds |
| Diversification | More diversified due to access to various markets and sectors | Less diversified due to focus on specific markets and sectors |
Which Is Right For You? ETFs Vs Mutual Funds Canada
There is no definitive answer to which is better: an ETF or a mutual fund. It depends on your personal preferences, goals, risk tolerance, time horizon, and investing style. Here are some general guidelines to help you decide which one suits you better:
Investing In An ETF Is Right For You If…
- You want to pay lower fees and expenses for your investment
- You want to be more tax-efficient and defer taxes on your capital gains
- You want to have more control over when and how much you pay for your investment
- You want to use different types of orders and strategies to enhance your returns or hedge your risks
- You want to follow the market or a specific index or benchmark
- You want to access various markets and sectors that are not available in mutual funds
Investing In A Mutual Fund Is Right For You If…
- You don’t mind paying higher fees and expenses for your investment
- You don’t mind paying taxes on your capital gains every year
- You don’t care about the timing or the price of your investment
- You don’t want to use different types of orders and strategies to complicate your investment
- You want to beat the market or a specific index or benchmark
- You want to benefit from the expertise and experience of professional fund managers
ETFs Vs Mutual Funds Canada FAQs
Which is better: an ETF or a Mutual Fund?
There is no definitive answer to which is better: an ETF or a mutual fund. It depends on your personal preferences, goals, risk tolerance, time horizon, and investing style. Both ETFs and mutual funds have their pros and cons, and you should weigh them carefully before making your decision.
Are ETFs more tax-efficient than mutual funds in Canada?
Generally speaking, yes. ETFs are more tax-efficient than mutual funds in Canada because they have lower capital gains distributions. This means that you don’t have to pay income tax on distributions and you won’t pay taxes on your gains until you sell your ETF shares. This can help you defer taxes and reduce your tax bill in the long run.
Are ETFs riskier than mutual funds?
Not necessarily. ETFs and mutual funds have similar risks, such as market risk, currency risk, interest rate risk, credit risk, and liquidity risk. However, some ETFs may have additional risks, such as tracking error risk, leverage risk, inverse risk, and counterparty risk. These risks depend on the type and style of the ETF, and you should understand them before investing in them.
Are ETFs Good for beginners?
Yes, ETFs can be good for beginners who want to start investing in the Canadian market. ETFs can offer low-cost, diversified, and easy-to-trade exposure to various markets and sectors. However, beginners should also be aware of the potential pitfalls of ETFs, such as commission charges, bid-ask spreads, tracking error, and complex strategies. Beginners should also do their research and due diligence before investing in any ETF.
