ETFs combine the ease of stock trading with the diversification benefits of managed funds. While ETFs, managed funds, and stocks have similarities, understanding their differences is key to ensure you select the appropriate vehicle.
How similar are ETFs to managed funds and individual stocks? Compare these three investment vehicles:
ETFs and managed funds either seek to track or try to outperform the performance of an index, such as the S&P / ASX 200 Index. They provide access to many companies or investments in one single trade, removing single stock risk, or the risk inherent in being exposed to just one company.
This diversification across many securities can dilute the potential negative impact of poor performance that any one security may have, thus lowering the risk that an individual stock could hurt the portfolio’s overall performance.
Both ETFs and managed funds have an expense ratio, which includes management fees and the fund’s total annual operating expenses. Historically, index ETFs have had a lower average indirect cost ratio —0.39%,1 while index managed funds have had a higher average indirect cost ratio —0.57%.1 Individual stocks do not have an expense ratio.
Because ETFs and individual stocks are bought and sold on an exchange, they are both subject to a transaction fee (or commission). Managed fund transactions do not incur commissions, but may incur other sales charges.
It’s important to consider the total cost of ownership (TCO) for any investment, both the expense ratio and the trading costs.
You can find out more about TCO here.
Because investors can buy and sell ETF shares on an exchange continuously throughout the day, like individual stocks, ETF pricing captures the current market price. Their cost may be slightly more or less than their net asset value (NAV).
Managed fund shares are priced once at the end of the trading day. Investors purchase and redeem units at the closing value of the fund. The price or net asset value (NAV) is the value of the fund’s assets, less liabilities, divided by the total number of units outstanding.
Similar to individual stocks, with ETFs, there is no minimum investment requirement.2 An investor can purchase as few as one ETF share or as many as preferred. Managed funds may require investment minimums.
When an investor decides to sell ETF shares or individual stocks, any associated capital gains tax is paid at the time of final sale. This offers greater control on the timing of tax consequences.3
In contrast, when an investor decides to sell a share of a managed fund, the fund manager may sell a portion of the fund’s security holdings in order to deliver cash in the amount of an investor’s position. This sale may generate a realised taxable gain, and taxes on those gains are absorbed by the remaining investors in the fund.
1 Source: State Street Global Advisors, Morningstar Direct, as of 31/12/2020. The average Max Management Fee for Indexed ETFs and Indexed Open End Funds as defined by Morningstar. Morningstar define the management fee as the maximum percentage deducted from a fund’s average net assets to pay an advisor or subadvisor. It is collected from the prospectus.
2 Subject to brokerage rules/costs/fees.
3 However, changes in an ETF’s underlying index could trigger the sale of securities which, in addition to transaction costs, may trigger capital gains distributions. In this scenario, any realised gains or losses are passed on to ETF investors. To ensure tax efficiency, ETF managers attempt to limit these types of transactions as much as possible.
Closing Net Asset Value
A mutual fund’s price per share value based on the closing market prices of the securities in the fund’s portfolio.
The current price at which an asset is bought or sold in the marketplace.
Net Asset Value (NAV)
The price of a share determined by the total value of the securities in the underlying portfolio, less any liabilities.