The Difference Between ETFs and Mutual Funds is Capital Flow

The differences between ETFs and mutual funds are fees and accessibility. But the biggest difference is the way capital flows and who gets paid.

Most people believe the difference between mutual funds and ETF is that ETFs are index-tracking funds, and mutual funds are actively managed funds. While this is true in many cases, it does not tell the entire story.

Let’s start with what ETFs and mutual funds have in common.

The similarities between ETFs and mutual funds

Both ETFs and mutual funds can be index-tracking and passively managed funds. Additionally, both mutual funds and ETFs can be actively managed funds with a team of researchers and a nominated fund manager.

ETFs vs. Mutual Funds ETF Mutual Fund
Index Funds
Actively Managed
Passively Managed
Fund Managers
Research Teams

Table: ETFs vs. Mutual Funds Similarities

Both ETFs and mutual funds can passively track an index, sector, or industry, but additionally, they can both be actively managed funds trading in exotic assets like currencies, property, bonds, derivatives, and swaps.

The difference between ETFs and mutual funds

The three big differences between ETFs and mutual funds are that ETFs are traded openly on an exchange, have better tax efficiency, and generally have lower costs. Mutual funds are bought and sold directly or via a financial advisor through the fund company.

When you sell your shares of a mutual fund, the fund manager sells the stocks, and you typically incur capital gains tax; this is generally avoided with ETFs.

Differences between ETFs and mutual funds

ETFs vs. Mutual Funds ETF Mutual Fund
Index Funds
Actively Managed
Passively Managed X
Fees 0% – 0-6% 1% – 3%
Trade like stocks X
Fund Pricing Real-time End of Day
Tax Advantages X

Table: ETFs vs. Mutual Funds Comparison

The big difference between ETFs and mutual funds is capital flow

The biggest difference between ETFs and mutual funds is how capital flows from you, the investor, into the stocks and assets you are purchasing.

When you purchase an ETF, you transfer money to an online broker; then, you purchase the ETF through an exchange. If someone is selling the ETF, you are matched with them for the trade; if not, the capital is treated as an inflow to the fund, and the fund manager purchases extra assets.

When you purchase a mutual fund through a financial advisor, they will take care of the paperwork and manage your investment portfolio and reporting. For this service, the financial advisor receives a commission from the mutual fund, which is usually a cut of your annual fee; this is why fees are usually higher for mutual funds.

The image below shows the flow of capital from you into the assets purchased.

The difference between ETFs and Mutual funds is the flow of capital. Green arrows are ETF capital flows, blue arrows are mutual fund flows.
The difference between ETFs and Mutual funds is the flow of capital. Green arrows are ETF capital flows; blue arrows are mutual fund flows.

Capital flow when purchasing an ETF

  1. You open an account with an online broker
  2. You transfer money into your brokerage account
  3. You purchase an ETF, and your broker routes the trade through an exchange
  4. Your ETF purchase is exchanged with someone selling the ETF or routed to the fund who then purchase more equities or assets
  5. When you sell your ETF, the transaction is with someone buying the ETF on the exchange (which avoids capital gains tax), or the fund liquidates the assets meaning you incur capital gains tax.

Capital flow when purchasing mutual funds

  1. You purchase a mutual fund through your financial advisor or directly with the fund management company, Vanguard, Schwab, Blackrock, etc.
  2. The fund management company purchases the extra securities, stocks, derivatives, bonds, or currencies.
  3. When you sell shares in a mutual fund, the fund management team liquidates the assets, and you incur capital gains tax.
 

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