Considerations Involving Mutual Funds and Exchange-Traded Funds

E*TRADE from Morgan Stanley (“E*TRADE”) offers investors the ability to invest in mutual funds and exchange-traded funds (“ETFs”), which many people use to pursue their financial goals.  Both mutual funds and ETFs offer investors the ability to invest in diversified pools of securities that follow a variety of investment strategies with exposure to various types of asset classes.  Despite these similarities, it is important for you to understand the differences between these products with respect to: (1) how they are priced, (2) their fees and expenses, and (3) tax efficiency.  The following information pertains to domestic mutual funds and ETFs.

Pricing

Mutual funds and ETFs are priced in different ways.

Purchases and redemptions of mutual funds are priced in accordance with the net asset value (“NAV”) of a fund.  A fund’s NAV is calculated by (1) taking a fund’s assets, which include the fund’s securities and cash, (2) reducing that sum by the fund’s liabilities, which include its fees and expenses, and then (3) dividing that sum by the number of shares outstanding.  This means that a mutual fund is valued by reference to its actual investments. 

Most mutual funds determine their NAV at the end of each trading day, which is typically 4:00 p.m. ET.  As a result, if you place a purchase or redemption order for a mutual fund at 10:00 a.m. ET, you will not know the final terms of your transaction until after the end of the trading day, when a final value for each of the fund’s underlying assets is ascertained.  In this way, although mutual funds generally require investors to wait until 4:00 p.m. ET for final trade values, those values are derived from the actual investments held by the fund.

Purchases and redemptions of ETFs, on the other hand, are priced differently.  Shares of ETFs are bought and sold on the secondary market (e.g., on stock exchanges), which means that investors do not transact with funds at prices based on NAV.  Rather, the price of an ETF share is determined by the market—i.e., the price the buyer and seller of ETF shares agree on—as opposed to the value of the assets held by the ETF.  One benefit of trading in this manner is that investors can buy and sell ETF shares throughout the trading day and instantly know the price at which they transacted. 

Trading ETF shares in the secondary market, however, can impact the liquidity and the price of an ETF’s shares.  If an ETF has a lower trading volume, an investor may have to accept a lower price to sell their ETF shares in the short term.  This risk may be pronounced during times of market stress or if more market participants want to sell rather than buy an ETF’s shares.  Any of these situations, among others, could lead to an investor selling their shares at a “discount” to what the ETF’s underlying holdings are actually worth.

Other trading scenarios can cause ETF shares to trade at higher prices than what the ETF’s underlying holdings are worth (i.e., buying shares at a “premium”).  Purchasing ETF shares at a premium and selling those shares without a premium, or at a discount, can significantly affect the realized return earned by an investor, with it being likely that such realized return would substantially differ from the return of the ETF’s market price or the performance of its underlying holdings and, if applicable, the index the ETF may seek to track.

ETFs rely on large institutions to make a market in their shares, which provides liquidity to the trading of the ETF and can help keep the market price of ETF shares close to the ETF’s NAV.  Although this process has been generally successful, market disruptions, new types of ETFs and/or other events can make it challenging for such institutions to continue their market-making activities.  This means that ETFs can trade at discounts to their NAVs, which will negatively impact ETF shareholders, particularly those that need to sell their shares at such times.

Taken together, when considering an investment in ETFs, you should consider the effects of trading in the secondary market.  In addition, certain platform providers may limit the availability of ETFs to retirement plans. 

Lastly, it bears noting that mutual funds and ETFs can also differ in terms of how often each product discloses its portfolio holdings.  Mutual funds, for example, publish their holdings after each quarter end.  Many mutual funds also display their top-10 holdings throughout the year.  Many ETFs, however, publish their holdings on a daily basis.  A minority of actively managed ETFs, however, meaning those that seek to outperform an index or other benchmark, disclose their holdings less frequently than daily.

Fees and Expenses

Fees and expenses are an important investment consideration because they reduce investment performance.

Although the overall investment costs an investor pays will depend on the types of funds being considered, you should know that many ETFs are less expensive than similarly managed mutual funds.

For example, certain mutual fund share classes, but not ETFs, are subject to so-called 12b-1 fees, which are ongoing fees charged against mutual fund assets paid to E*TRADE for marketing, distribution and/or shareholder services costs.  Because E*TRADE offers many mutual funds in share classes that do not pay 12b-1 fees, you should consider the differences in payment structure between 12b-1 and Non-12b-1 share classes when investing.  The Non-12b-1 paying share class will almost always have lower annual expenses which directly increases your investment return.  This effect is even more pronounced over time and at higher investment levels given that 12b-1 fees are continually applied against an investor’s holdings in a fund.  Since in many cases, both 12b-1 and Non-12b-1 paying share classes will be available for a given fund option, investors will typically benefit from selecting Non-12b-1 paying share classes over 12b-1 paying share classes of the same fund.  

Mutual funds, but not ETFs, also generally provide E*TRADE with compensation for providing record keeping and related services, which can lead to mutual funds, including those in non-12b-1 paying share classes, to be more expensive than similarly managed ETFs.

Further, E*TRADE charges most fund families a support fee, also called a revenue-sharing payment, on client account holdings in fund families.  Although revenue sharing payments are generally paid by the sponsors of mutual funds and ETFs, and not by the investors in such products, it bears noting that E*TRADE charges revenue sharing fees to more mutual funds than it does to ETFs.

Because E*TRADE generally receives more compensation from mutual funds than it does from ETFs, E*TRADE has a financial incentive to promote mutual funds, which is a conflict of interest.  In order to mitigate this conflict, E*TRADE seeks to charge the same revenue sharing rate schedule for mutual funds and those ETFs that are subject to revenue sharing.  E*TRADE also does not receive 12b-1 fees from certain share classes of mutual funds.    

For more information on 12b-1 fees, administrative services fees and revenue sharing payments, including the conflicts of interest associated with them, please see the disclosures titled “Mutual Funds” and “Exchange-Traded Funds,” which are available in the Disclosure Library at etrade.com. 

Tax Efficiency

Although it can vary by fund, ETFs are often more tax efficient than mutual funds.

Mutual funds and ETFs are generally required to distribute dividends and net realized capital gains on their holdings to shareholders.  Unless a mutual fund or ETF is held in a tax-advantaged account, investors will typically have to pay taxes on such gains and income.  This is true even if the fund loses value during a given tax year.

The manner in which ETFs create and redeem their shares typically allows ETFs to experience fewer net realized capital gains.  For investors utilizing taxable accounts, investing in ETFs could increase their returns on an after-tax basis, as compared to investing in a similarly managed mutual fund.  Please consult with your tax advisor on the tax implications of investing in mutual funds and ETFs.  E*TRADE does not provide tax advice.

Conclusion

Mutual funds and ETFs allow investors to pursue professionally managed and diversified investments in convenient packages.  Each product, however, has different characteristics regarding pricing, fees and expenses, and tax efficiency that should be considered.

Please carefully review a fund’s prospectus before investing.  The prospectus contains important information about fees, risks and investment objectives and should be carefully considered before investing.