Understanding mutual funds and ETFs

Editor's Note

This article is sponsored by Hall O’Brien Wealth Counsel

An alphabet soup

There are so many acronyms and variables in investing and financial planning, it can be a challenge to keep it all straight.

  • There are different account types: Registered accounts that have special tax attributes (e.g. RRSP, RESP, RDSP, TFSA, LIRA) and non-registered accounts that do not have special tax status. 
  • There are different investment types: Stocks, bonds, preferred shares, mutual funds, ETFs (exchange traded funds), GICs (guaranteed investment certificates), money market, flow-through shares, REITs (real estate investment trusts). 

Many people are embarrassed to ask for explanations about the meaning of these different investment types and I have often had new clients answer “RRSPs” (an account type) when I ask what they are have experience investing in or “GICs” (a type of investment) when I ask what types of accounts they have.

In order to simplify the concepts, I like to use the analogy that account types are different “buckets,” and the types of investments are what go into the buckets. 

It can be intimidating to have a meaningful conversation with your advisor if you aren’t comfortable with the terms being used in your review meeting and you may feel you are missing some elements in your financial and investment plan.

One thing at a time

While the terms above are thrown about without much thought, we get a significant number of questions about the difference between mutual funds and ETFs so we will focus this article on defining and differentiating the two – taking a bite out of the metaphorical alphabet soup so to say.

There are a few ways investors can invest in publicly listed companies that are listed on the stock markets. They can buy individual shares, they can buy mutual funds or they can buy ETFs.

In both cases a mutual fund and an ETF hold a variety of stocks of different companies – these are known as a portfolio. For example, mutual funds and ETFs can hold:

  • Stocks that represent a whole market (e.g. “Canadian equity”)
  • Stocks from only a particular sector (e.g. financial or health care)
  • Stocks of a particular type (e.g. “dividend payers”)

The primary difference between these two investment types is how the portfolios are selected.

Taking the bull by the horns

A mutual fund is an “actively managed” portfolio of stocks. A portfolio management team will select a subset of all the available stocks to hold in the portfolio. Typically, this is represented by the TSX 60 Index when thinking about large Canadian companies and the S&P 500 when thinking about large American companies.

A mutual fund manager will try and choose a subset of stocks that will perform better than the broad market it represents. For instance, if a mutual fund manager is choosing stocks for a Canadian equity portfolio, they will want to choose a portfolio of stocks that excludes stocks that they believe are not as attractive as other Canadian companies and include stocks that are more attractive than the others.

The term “actively managed” lies in the amount of work the portfolio management team undertake in analyzing, selecting and managing the stocks to hold in the mutual fund. The team may meet with management of the companies they are analyzing, they will do in-depth financial analysis of the companies’ financial statements, growth projections and cash flows as well as assess the outlook for the sectors in which the companies operate.

They will also evaluate the companies against their competitors and also choose stocks that are more immune to drops in price when the stock market pulls back or corrects.

Because there is a portfolio team researching and analyzing all the available opportunities and doing significant work to select the companies for the portfolio, they charge a fee for this service that is known as the management fee. This fee plus the cost of trading and taxes together are the “MER” or management expense ratio. This fee is charged as a percentage of the value of the fund and therefore creates a drag on the performance of the fund. 

A more passive approach

Exchange traded funds started out as “passively” managed funds. When ETFs first came into being, investors could invest in a fund that held all the stocks that make up the TSX 60, for instance. As companies within the index grew, individual companies could begin to represent a larger and larger portion of the portfolio. 

The most famous example of this became known as the “Nortel effect.” The value of Nortel grew so much in 2000 that its market capitalization (i.e. the price of its stock times all the outstanding shares) represented more than one-third of the S&P/TSX Composite Index. Then, its share price plummeted 82 per cent and Nortel wound up representing less than 10 per cent of the index. Investors who held a TSX Composite Index ETF would have seen the value of their fund drop dramatically in conjunction with the drop in the price of Nortel.

Since then, many ETFs have added different rules to reduce the risk of simply holding a market index and to narrow the set of stocks held in the fund. A common rule is to limit any one company to no more than a certain percentage of the portfolio. Other rules can be based on a wide variety of factors such as earnings growth, the momentum of a stock – the extent to which a stock moves up and down relative to other stocks in the market – or whether or not the company is paying or growing its dividend.

These rules are often applied in a systematic, mathematical-based way and do not require as much manpower to manage. ETFs therefore tend to be lower-cost than mutual funds but do tend to participate in, or follow, the ups and downs of the “market” more closely.

An example to bank on

To highlight the difference between the two, consider banks. There are several publicly listed tier-1 banks in Canada. They are all part of the Canadian equity market. A Canadian equity ETF will by its nature hold all of the banks. However, a mutual fund portfolio manager will consciously choose a subset of the banks, selecting the ones they think have better management, better growth opportunities and that they believe will translate into better appreciation of its stock price relative to the other banks. 

There are different arguments for one approach versus the other and it largely comes down to personal philosophy.

If you still have questions about mutual funds vs ETFs, you can reach me at Joelle.Hall@RichardsonWealth.com

This article is supplied by Joelle Hall of Hall O’Brien Wealth Counsel, an Investment Advisor with Richardson Wealth. 

Hall O’Brien Wealth Counsel specialize in tax-efficient portfolios and planning. We speak your language so you feel confident in the plan we implement together.

www.HallOBrienWealth.com 

The opinions expressed in this report are the opinions of the author and readers should not assume they reflect the opinions or recommendations of Richardson Wealth Limited or its affiliates. Assumptions, opinions and estimates constitute the author’s judgment as of the date of this material and are subject to change without notice. We do not warrant the completeness or accuracy of this material, and it should not be relied upon as such. Before acting on any recommendation, you should consider whether it is suitable for your particular circumstances and, if necessary, seek professional advice. Past performance is not indicative of future results.

Richardson Wealth Limited, Member Canadian Investor Protection Fund. Richardson Wealth is a trademark of James Richardson & Sons, Limited used under license.

From the archives