Main Talking Points
[1:30] – What is a Mutual Fund?
[5:58] – Define “Closed End” & “Open End”
[11:10] – The Term “Load”
[13:01] – Expense Ratios
[16:41] – What is an ETF?
[20:01] – Dad Joke of the Week
[20:40] – Pros & Cons of ETFs and Mutual Funds
[29:19] – Which One is Better?
[34:46] – The Key to ETFs & Mutual Funds
Links & Resources
History of Mutual Funds – Investment Funds Institute of Canada
Net Asset Value vs Price – Zack’s
Invest With Us – The Invested Dads
Free Guide: 8 Timeless Principles of Investing
Social Media
Full Transcript
Intro:
Welcome to The Invested Dads Podcast, simplifying financial topics so that you can take action and make your financial situation better. Helping you to understand the current world of financial planning and investments. Here are your hosts, Josh Robb, and Austin Wilson.
Austin Wilson:
All right, hey, hey, hey, welcome back to The Invested Dads Podcast, a podcast where we take you on a journey to better your financial future today, Josh, we’re talking about ETFs and mutual funds.
Josh Robb:
ETFs, that stands for eggs tastes funny. Or if I listened to my 11 year old ETF stands for, and he uses this phrase, ETF means estimated time of fart.
Austin Wilson:
Okay, sidebar, we have a 13 year old Australian shepherd, Sophia. She has got worse gas than any human, than any human I have ever known. And she’ll be laying on the floor next to us and we’re watching TV and it just rips a room apart.
Josh Robb:
Oh, yeah.
Austin Wilson:
So, how long does that fart last? Long time.
Josh Robb:
Long time.
Austin Wilson:
So, no, Josh, not those things.
Josh Robb:
No, that’s not, it.
Austin Wilson:
ETF stands for exchange traded fund. And today we’re going to look at the difference between mutual funds and ETFs and maybe what’s best for general investors or maybe for you.
Josh Robb:
Yeah. So exchange traded fund, mutual fund, they both have the word fund in them. So they’re probably the same thing.
[1:30] – What is a Mutual Fund?
Austin Wilson:
It’s a fund thing to talk about. A lot of fund. Yeah. They do have similar characteristics, but let’s kind of break down each one before we go as to how they compare. So, mutual funds, Josh, what is a mutual fund? How did that get started?
Josh Robb:
Yeah. So let’s do a little history class here. Yeah. The first mutual fund that is really kind of can be tracked back. I saw some that had it even farther back, but it was kind of weird, but the first kind of real one that could be related to what you would call today was created by a Dutch merchant in 1774.
Austin Wilson:
Two years before America was bore.
Josh Robb:
Born?
Austin Wilson:
I was trying to rhyme with 1774. It didn’t work.
Josh Robb:
The idea there though was, and there’s a great article by the investment funds Institute of Canada, which we’ll link in the show notes.
Austin Wilson:
Bunch of loonies.
Josh Robb:
Yeah. And toonies. But they had article and that kind of went through the history, but this fund was created in what you described in the modern day mutual fund is he grouped a bunch of people’s investments together to give smaller investments, a larger pool to access bigger purchases. And so the way he did, he created these, in a sense, 2000 shares of this fund he created and 2000 investors or groups of investors could put money in and then he would go out and buy, he was buying land and stuff is what he was doing. But the idea there was then once those 2000 shares were done, his little fund was full and he was going to use the money and grow it. But if somebody else wanted to get in on that, they’d have to convince somebody who owned a to give it to them or sell it to them, which is kind of what you think about modern day trading, right? And so that was the start of it.
Austin Wilson:
It’s kind of like a closed end fund. Which we’ll talk about that later.
Josh Robb:
And that’s exactly what it was.
Austin Wilson:
So, wow. 1774. So, that is old school. Not necessarily the way that we think of mutual funds today, but in general, think of pooled investment vehicle in this case, 2000 people or whatever shareholders pooled their money to go invest in land and other crap. So now modern day think modern day mutual fund that kind of begins around 1924 and that was called the Massachusetts Investors Trust. So it was the first mutual fund with an open end. So as opposed to closed end, so new shares can be created all the time, capitalization and that allowed, yeah, continuous issue, but not only issue, but also redemption of shares by the investment company. So after just one year, that fund grew to $392,000 in assets from 50,000 starting out. Now that may not sound absurd today, but in 1924, that was a chunk of change.
And this fund went public in 1928 and eventually became known as MFS invests, or MFS investment management. So Scutter, Stevens, and Clark was an outfit that launched the first no load fund, which we’ll also talk about in a little bit in 1928. So that was a big year.
Josh Robb:
And that was just four years after this first one.
Austin Wilson:
…four years after the first one. So then the first one went public in 1928, same year. And then the first no load fund started also that year. So that was a big year in the history of mutual fund. The Wellington fund started that year. And that was the first two include stocks and bonds, as opposed to merchant bank style of investments in businesses and trade. So 1928 big time, not a great time, if you look at a stock chart to really get started investing in stocks, but that’s how it worked.
Josh Robb:
But what you’ll find there too. And part of the reason with that timing and what Austin’s referencing is there was the great depression that showed up. The thirties, 1930s was not a good years to be invested in this stock market.
Austin Wilson:
Well, the stock market cut in percentile, very, very, very small amount.
Josh Robb:
Yeah. And so the idea there though is though these open-end mutual funds, especially the ones that we’re investing in stocks and bonds had some flexibility there, whereas a closed in funds, and we’ll talk a little bit about both of those. A lot of those closed down because they were leveraged, and they do a lot of crazy stuff there in some of those closed end funds. And so they became popular kind of as a result of that, because they survive through that depression era and the crazy volatile stock market. And to say, okay, if I am going to be putting my money in something, someone managing this, and having a mixture of stocks and bonds is it looks like at least able to help get an investor through those, especially an investor who maybe isn’t as educated, or as paying attention as an investor would.
Austin Wilson:
So, we talked about a couple of terms that we should probably break down further, Josh. We mentioned the term closed end and open end. What do those mean?
[5:58] – Define “Closed End” & “Open End”
Josh Robb:
Yeah. So, that references how you buy shares into that fund. So a closed end mutual fund means that the fund manager created a set amount of shares. So, whether it’s 2000, we talked about that first one or 2 million, it doesn’t matter. You say these are as many shares of this fund and once they’re out, they’re out. And so the company sells those set amount of shares out on the ARCA. They set a price and people buy them after that it’s traded based on the demand for those shares. So, a stock that goes up and down. Now what happens with closed end funds though is sometimes the value of what they actually hold, and the price it’s trading for, won’t match.
Austin Wilson:
And there’s a premium or a discount. Either one.
Josh Robb:
So, a premium meaning you’re actually paying more than what it actually holds in that fund for the right to own those shares. Somebody else’s, you want it so bad from somebody you’re going to pay them a little extra.
Austin Wilson:
So, a open end fund or an ETF as we’ll talk about soon, as opposed to that, is trading on the supply, and the demand is setting the price of the actual underlying assets at any given time. But in a closed end fund, you’re actually trading the price is trading, and what you’re buying it for is the supply and demand for the fund. Not necessarily the underlying asset balance.
Josh Robb:
Yes. For the, in a sense, the right to own a piece of that fund, whereas an open end fund, like you said, at the end of every day, they value their overall assets. And then they set their price. It’s called the NAV net asset value, meaning their total of their assets. And then they take that by the number of shares. And so then if I want to buy a new share or sell mine back, my transaction is with the fund manager with that fund company, I say, I want money back, or I want to give you money for more. And they then say, “Okay, this is how much my total values divided by that.” Here’s how much it cost to buy or take back the shares. So the transactions are done once a day.
Austin Wilson:
Yeah. And I guess it’s probably important to point out where transactions occur and for a closed end fund or an ETF, both at the same way, that occurs only on an exchange. And that occurs only if you have, think of a brokerage account with a custodian who can buy, and sell on the exchange. A open end fund, however, like you said, it is the actual manager who is doing all of that. It is not custodian.
Josh Robb:
Yeah. There’s no middle people there. There’s no third party or anyone outside of the fund manager and the person buying or selling.
Austin Wilson:
So you mentioned NAV, net asset value. So I wanted to clarify one thing. So yes, you were right. That is what mutual funds specifically open-ended mutual funds transact at, but the actual calculation takes all the securities plus any cash you’ve got that the fund then owns minus any liabilities. So, that’s the net part. And then that’s divided by the number of shares that were outstanding. And like you said, that’s published once per day, but let’s just get that very, very clear. That’s typically what people talk about with mutual funds as a quote unquote price, because that’s the best we got. There really is no real time price in the middle of the day that’s what’s published. That’s what one shares worth once a day. So that is like a dollar figure share of a fund that it would be worth if it was liquidated. So, you own one share of this mutual fund. If that mutual fund were liquidated tomorrow, all the securities and cash minus any liabilities, your one share worth of that is what NAV is. Now, price, price is price, price is based on supply and demand in real time.
And that is what you’ll typically see when you’re looking at an ETF, although ETFs do have NAVs as well, but price is going to be based on supply and demand in the market. And like you mentioned, keep in mind that specifically with closed end funds and with ETFs, those can be at a premium or a discount to NAV where open end fund are going to be pretty much at NAV plus or minus a very, very small margin. Now I do want to point out that liquidity also changes that. So, with a closed end fund, the liquidity can be more of an issue which can also exacerbate the premium, or the discount. And actually Zack’s Investment Research posted an article on it. We’ll link it in the show notes, but when they wrote the article, there was, they said that variations over 10% for closed end funds are not uncommon. And there was a closed end fund with a discount to NAV of 29%, which sounds like a lot.
Josh Robb:
Yeah. So, in a sense, if I buy a share that closed end fund and they were just to liquidate, I actually have 30% more than what I paid for of the value there.
Austin Wilson:
But there was another fund that was trading at a 78% premium to NAV.
Josh Robb:
Tell the other way around.
Austin Wilson:
You’d be toast. You’d have like 20% of what your actual dollar is worth. So, interesting.
Josh Robb:
You’re really betting on the manager to outperform at that point.
[11:10] – The Term “Load”
Austin Wilson:
So yeah, I buy a lot too. It’s not just a couple percent. You’re putting all eggs in his basket. So, another term that I hear come up specifically when it talks, when we’re talking about mutual funds, is load. So, Josh, what is load? No load. Yes, load. Load.
Josh Robb:
Yeah. So…
Austin Wilson:
Give me the load down.
Josh Robb:
Yeah, so a load is a term we use for a cost to purchase. And so if you hear, in a sense, we talked about being the first no load mutual fund. So that would mean there’s no cost for purchase of that mutual fund. Now load another way for that is commission a better word, maybe that more people relate to is commission. And so if there’s a low to mutual fund, there can be a front load, which means you pay the commission when you purchase it, then there’s a backend load, which means you pay the commission when you sell it. And then there’s some other stuff in between. But in general, if there is a load, it means at some point in time, you’re going to pay a commission for whoever that person is making the transaction, no load being the other way round is there is no cost buying or selling or wherever for that.
Now, since there is, when I’m talking, no load, that’s the cost for the transaction. There’s still an underlying and this is true for closed end open-end and ETFs. There is an expense ratio or an expense for the management of these funds, because again, a fund is pooling a group of investments together. So there’s people involved, and there’s costs involved. There’s really no way around it. There are a couple commission, and expense free ETFs out there, but they’re totally different. I think Fidelity has a couple and they’re a way of just getting business to their firm, really offsetting at other places there’s costs involved.
Austin Wilson:
I mean, I’m sure that there is, the expense ratio might be ultra low.
Josh Robb:
I think there’s a zero.
Austin Wilson:
Zero zero? I did not know there was a zero, zero.
Josh Robb:
I think so. We’ll have to pause real quick and I’ll have to look that up.
[13:01] – Expense Ratios
Austin Wilson:
That is the race to the bottom at its best. So, expense ratios, that is pretty much, yeah, that’s the cost that your paying the managers to manage. Now, that’s going to be, like you said, for mutual funds or ETFs, whether that be open end or closed end you’re paying that no matter what. Expense ratios can vary wildly.
Josh Robb:
Yes. They’re all over.
Austin Wilson:
So there are actually a couple zero, zero, expense ratios.
Josh Robb:
And those are done from some large institutions. And it seems to be that they’re there to really bring business in and knowing that to be welly diversified, you’re also going to need some other stuff, so they’re going to pick it up somewhere else.
Austin Wilson:
But a typical index style, passively managed, which we’ll talk about in a second fund, equity fund, is going to be single digit basis point expense ratios.
Josh Robb:
So when you say basis points, when you think of percent, 1% is a hundred basis points. So, when you say single digits, that would be .02, .04% of an expense ratio.
Austin Wilson:
Its very, very low. Now actively managed, so to put the little bit of context here, actively versus passively managed, this is a big topic in ETFs, and mutual funds. The manager does not have to do a necessarily a ton of work to passively manage an S&P 500 ETF. So their goal is to mirror the weightings and the movements and everything of their holdings, as it relates to the actual S&P 500, that really doesn’t take that much. You can get it all the time. Now that’s passive. You’re just mirroring an actual something else now. And those were very cheap because it does not take much work. Now where it comes to active management, someone is literally trying to be different and trying to outperform an index, or whatever. And that is where the work comes in. And with work comes…
Josh Robb:
Cost.
Austin Wilson:
Cost.
Josh Robb:
And active can also be a combination, so maybe there is not an index that says it’s 60% stocks, 40% bonds. So you may have some asset allocation fund, which would be active, managed unless you’re combining two indexes together. But in a sense if you’re doing some sort of target, then you have some sort of active management overlaid on top. And so you’re adjusting that.
Josh Robb:
…target date funds are a good example of that, because they’re adjusting the allocation along the way, and you see that very popular in retirement plans and stuff. So that would be probably an example that you may be familiar with in your retirement plan is some sort of target date fund where they choose a year and they’re managing towards that year.
Austin Wilson:
And that maybe some sort of hybrid.
Josh Robb:
Yes.
Austin Wilson:
So, yeah they might use index funds or index ETFs or something, but they’re weighting those indexes, and changing it over time.
Josh Robb:
So there’s some active, there’s somebody somewhere making decisions or using some sort of algorithm to make those decisions.
[16:41] – What is an ETF?
Austin Wilson:
And there’s a lot of this in between stuff it’s kind of becoming popular now. And I’m thinking of stuff like this is not sponsored in any way, but there is a, Goldman Sachs, obviously a huge company in the finance world. They have some ETFs that are called active beta. And really what they’re doing is using an index list and they’re waiting certain characteristics of certain companies to increase the weights on some and decrease the weights on others to hopefully outperform over time. But it’s a model it’s done on a computer, which makes it pretty affordable. So that’s kind of a hybrid that’s becoming pretty popular right now. So yeah, that’s active versus passive and there is a lot of debate and we’ll probably have a full episode at some point debating active versus passive overtime. But as far as it relates to the cost, there is a difference.
There’s definitely a difference. So ETF in general exchange traded fund similar in many ways to a mutual fund, it’s where people pool their assets together. But instead of waiting at the end of the day for the NAV to get published, you can trade it real time when the stock market is open, because it’s traded on an exchange, see what they did there. They were real good at naming.
Josh Robb:
…good name for it then.
Austin Wilson:
Real creative. And you can buy and sell it like a stock anytime the market’s open. And there is a lot of transparency. And the transparency is key because specifically as it relates to mutual funds, mutual fund managers are not required to disclose their movements or their holdings other than one time per quarter. And that is what was called a 13 F is published to the SEC, by the fund manager, once a quarter after the end of the quarter where they say, here’s all of our holdings at the end of the quarter or whatever.
Josh Robb:
Which is, again, if you’re watching your investments and especially, let’s go back to earlier in 2020 this year where we were looking at some crazy volatility, if you’re wondering what is going on with the stuff I hold an ETF, you’ll know. A stock, you’ll know what’s happening because they have to also release public information. A mutual fund, you’re going to be waiting two to three months, depending on where you’re at in the quarter, before you even see or hear what they did. And so, yeah, there’s a little bit of lack of transparency there.
Austin Wilson:
So, that’s another benefit. And especially a lot of finance professionals have the ability to actually look into holdings and with mutual funds, if you look into holdings, you can only see it as of the last 13 F filing. That’s the best detail you can find, but with an ETF, you can look at it real time, real time during the day and see what’s doing well, and what’s doing not, and what’s changing.
And I’m thinking of, we use Bloomberg here at the office, we’ve got some Bloomberg terminals and we have the ability to compare a fund and a mutual fund, two different mutual funds, a fund, an ETF, whatever. And we can see we like using ETFs because we can run it.
Josh Robb:
…see exactly what’s going on.
Austin Wilson:
So, it’s a really, really handy thing that I think has brought, I think, it’s one of the pushes for management from investment management perspectives that people like ETFs
Josh Robb:
…we’ve seen a lot more ETFs and you see, they call it fun flows, meaning what’s going in and out of funds. We’ve seen a lot more money moving towards ETFs because of that transparency and ease. And we’re going to start talking about that now, when we look at the pros and cons is one of the benefits is is we’ve gotten better, technology trading has gotten a lot easier.
You used to have to pay $30 a trade for a mutual fund. And when we go back to, and that was the transaction cost. That’s not even the commission, the load, I mean, it’s just crazy. So it was very hard to efficiently do this. And then they’ve reduced that down. And now for most advisors, you’re paying zero cost for the transactions, which is great. And then the same is true now with ETFs, …trade like a stock, most platforms now allow free or extremely low commissions or trade transaction costs for mutual funds and ETFs. So, in a sense, those are now on an equal playing field, which is great, which then goes to okay, if they’re both the same, what’s the next thing. We look at some of the positives and negatives.
[20:01] – Dad Joke of the Week
Austin Wilson:
But Josh, I think I’m getting a little tired of this nitty gritty. This is the nuts and bolts of investing. So, I need a little pick me up.
Josh Robb:
You need a little pick me up.
Austin Wilson:
What you got?
Josh Robb:
I got a couple. All right, but…
Austin Wilson:
For reference, this is the dad joke of the week.
Josh Robb:
Dad joke of the week. Here we go. I made a pencil with two erasers the other day, just kind of was playing around, but it was pointless.
Austin Wilson:
I was trying to figure out how that would work.
Josh Robb:
And then last one, do you know it takes guts to be an organ donor?
Austin Wilson:
Takes guts that is…
Josh Robb:
…an organ donor I guess.
Austin Wilson:
Well done.
Josh Robb:
Okay. That’s all I got.
[20:40] – Pros & Cons of ETFs and Mutual Funds
Austin Wilson:
All right. So kind of the summary level of what we are about. So let’s talk about pros and cons of each kind of investment. So pros and cons of mutual funds. So those are like key characteristics that you guys need to take home today. Number one, pricing, which it’s really not pricing. Net asset value today. Published once per day and it’s after the market closes and that’s after the fund company, makes sure that they’ve reconciled all of the inflows and outflows and all the trades they’ve done.
Josh Robb:
Yep. Now that doesn’t mean you trade once the market closes. So if I need to make a transaction for a client and it’s for a mutual fund, I’ll place a trade. While the market’s opening at the end of the day, the fund manager takes all the people that want to buy all the people want to sell. And then that’s where they run their calculation.
Austin Wilson:
Yeah. So so if you have a account that holds mutual funds and you log in at 10 in the morning, you are going to see yesterday’s NAV as your price, quote, unquote price per share that you’re seeing there. If you log in then at probably not four o’clock, but five o’clock or six o’clock in the evening, you’ll probably see that actual days closing NAV that they’ve just published. So, NAV once per day, key descriptor for a mutual fund transparency was another thing that we talked about, very limited with mutual funds. And that’s kind of a downside from a lot of people because, first of all, you cannot trade it during the day as we talked about. So you couldn’t act quickly if something changed. Second of all, you don’t know what’s going on in the fund, other than the movement of the price or NAV, you don’t really know what’s going on until the end of the quarter after the fund company publishes their 13 after the SEC.
Josh Robb:
Now I will say part of the reason why they have that is managers make the argument that in order to keep their advantage from competitors, they cannot be publishing if they’re being active and trying to beat other peers and the benchmark or whatever it is. If I tell you what I’m doing and they imitate it, then they really eliminating my advantage. And the reason why people are willing to pay me more money. So that’s why they’re doing it.
Austin Wilson:
I was doing a mutual fund screen one time, and I’m not going to mention any names of fund companies, because I couldn’t even tell you who it was, but there was literally a mutual fund company that, well, all they did was mirror this mutual fund company, mirrored another mutual fund after their 13 F was published, and then charged for it. So I was like, that’s a little sketchy. So, transparency, very, very different. I think a good thing in the mutual fund bucket is the quantity of you just have a lot of options for actively managed funds.
Josh Robb:
Yes. If you think of some way of investing, chances are there’s a fund out there that does what you would like to see somebody like.
Austin Wilson:
…and some weird, obscure.
Josh Robb:
…crazy stuff. Yeah.
Austin Wilson:
Yeah. So, there are a lot of options and a lot of these options have significantly long track records. So, a company that has a huge tracker that record that comes to mind is American Funds or Capital Group. They have investment histories for some of the funds that you can still buy today, going back 80 years. So that’s pretty cool. Now that’s not the case with ETFs are kind of a newer thing and we’re going to hit on that, and soon. And also generally, because of the higher share of active management and mutual funds, the expense ratios are going to be higher, right? Like we talked about. So, as far as mutual funds go, those are the kind of the key things there. Also dollar cost averaging, so Josh 32nd description of dollar cost averaging.
Josh Robb:
Dollar cost averaging is where you put money in consistently over a set time period periodically throughout that time period. And what you’re doing is you’re averaging out the cost to buy that. So an example is let’s say over a one year period, and this is just a short timeframe works well over long periods, but over a one year period, let’s say every week you bought, so for 52 weeks you were buying and the price of whatever you’re buying, if it’s a stock, a mutual fund, doesn’t matter. It goes up and down during the year. Well, you’re going to average out all those weeks worth of prices and you’re going to get an overall better average than you would of trying to lump it into different times. So dollar cost averaging is, in a sense, averaging out your cost when you’re buying into a fund or going up the other way, if you dollar cost average is out, and consistently sell over a long period of time.
Austin Wilson:
And yeah, the partial shares are the key there. And so ETFs let’s flip the table. ETFs, as opposed to kind of the things we just talked about from mutual funds, the things that we need to take away and remember for ETFs, Josh, pricing.
Josh Robb:
Yes. So pricing is real time.
Austin Wilson:
Real time.
Josh Robb:
Opposite of what we’ve talked with mutual funds. If I want to know exactly right now, if I wanted to buy one, share of some ETF, I could go and look and say, okay, this is what it will cost me now. Whereas the mutual fund, I don’t know, until it closes what I’m actually going to pay for it. Transparency, again, since I know exactly what the price is that also know what the underlying holdings are and they’re very transparent on that. I know exactly what I’m buying, what I own. It’s all public information.
Austin Wilson:
Another cool thing about ETFs is that you can buy futures and options, contracts for ETFs, where that’s not the case with mutual funds.
Josh Robb:
Because there’s no way to know.
Austin Wilson:
Yeah. And these are exchange traded options. So if you’re into hedging or options trading, which I’m not advising anyone to go do any of that, but professionals do this. And a lot of people, a lot of professionals, they can hedge some risk out by having some long positions in their equities, individual stocks, and then have some short positions in some index fund ETF short positions to kind of offset the risk so they could sell those, if they have to cover some losses. It’s pretty cool.
Josh Robb:
Yeah. There’s some neat strategies out there. If you can understand and get your mind around it.
Austin Wilson:
And I think that the quantity of ETFs, there are million ETFs. There are tons of ETFs and they’re only growing because they’re becoming very popular, but a differentiator is the active ETFs are kind of new. There isn’t a ton. And so if you’re looking for active management thinking, there are some marketing efficiencies that a good manager could take advantage of. There are some options and they’re growing all the time, but there are very limited options at this point. I think that we have the same conversation in 10 years, the whole thing is going to look different.
Josh Robb:
Yes. Yeah. I think there’s a trend, like you said, towards more transparency, which means that ETFs are getting more popularity. And then we’re also looking at, like you said, the idea that it started out very passive, easy to do an exchange rate. And they found ways to be able to still have meet the requirements for all their publishing of all the data and everything while still being actively managed. And so we are seeing a lot more of that.
And then fractional shares, so a mutual fund, again, since I’m buying a portion of this, and they’re always doing this exchange, I could buy one 10th of a share because all they’re doing, they know their value of all their assets, like we talked about, and they’re just going to give me a portion of that. ETFs, for the longest time you had to buy whole shares like a stock if I want to buy one share, so whatever the price is, I have to have that money. Some custodians are allowing partial shares or fractional shares for ETFs and stocks now. And so that’s just, it’s new, it’s coming out, and I think in the long run again with technology, it’ll be a lot easier to do. And it’s really market movers. People who have the ability to float the difference is really what they’re doing. And so large custodians are able to offer that.
Austin Wilson:
I think that that’s specifically more geared towards the retail side of things. Or like if you, “Joe Schmoe” investor, you are opening up your own account to manage it by yourself. You may have the option to do the partial share thing where if you’re working with an advisor, your advisor may not, and that will probably change over time too, I’m assuming. This is a whole other topic, but I really think that partial shares as it relates to, I guess, mutual funds or stocks or ETFs or whatever on a cost basis, if you’re in a taxable account and you have a cost basis reconciliation, you’ve got to do at some point like that can get noisy. Was that 10th of the share or was it the 10th of the share that I bought the week before?
Josh Robb:
Yeah. And that’s where it comes down to the custodians obligation, to track that where you used to have to track it yourself on paper, which is crazy.
Austin Wilson:
I don’t want to do that.
[29:19] – Which One is Better?
Josh Robb:
But now a lot of times the custodian’s responsibility is keeping the cost basis for you. So, let’s step back. Okay. We just explained both of these, but we didn’t really tell you why it matters. And so which one is better? That’s the question. Now…
Austin Wilson:
I have a feeling, I know what you’re going to say.
Josh Robb:
You know what I want to say, right? So I say moderation all the time, but there really comes down to what is your investment goals? What are your objectives? What thing will best you meet those goals and objectives? It could be ETFs could be mutual funds. It could be a combination of them. A lot of times we’re seeing more and more of that combination. Okay. Here’s a passive thing that I’m trying to track. ETF makes sense. You know what? I kind of want an active manager in this piece of my portfolio mutual fund is where I can find that. So you see a combination of those a lot of times. Now, one that we did not talk about and we did do a episode on taxes is between the two. There is a little bit difference in taxes as well. So a mutual fund because they pull these in and they’re always exchanging things in and out. They are periodically buying and selling their underlying holdings to match those redemptions. And so periodically mutual funds will have capital gains distributed. Usually at the end of the year.
Sometimes they do it semi-annually, but they’ll send that even if you haven’t done any transactions. So if I own my own accounts, taxable count and I haven’t bought or sold, but I own 10 shares of this mutual fund. They may at the end of the year, say by the way, anybody that holds shares one penny per share is going to be distributed to you in capital gains. So I have 10 shares, so I have 10 pennies now that are capital gains, in a sense that means on my taxes, now, I’m going to show capital gains and be taxed on that. Even though I actually didn’t do anything. ETFs while they can do that are usually more efficient. You see very few ETFs charge capital gains periodically. It’s really on your transactions when you actually have to pay. So there is one advantage there again, when it comes to taxes, that ETFs tend to have less of unforced taxes throughout the time from your holding.
Austin Wilson:
It’s also probably noteworthy that both ETFs and mutual funds can, and many do pay dividends. And that is going to be taxed like any other dividend.
Josh Robb:
Or differently, depending on what they’re owning, you may have qualified, unqualified dividends. Some may be municipal income where it’s tax-free. So you’re right. But will have to result for on your taxes. However, they kick that out. What you’re earning.
Austin Wilson:
So, but yeah, don’t think that just because you’re buying a pooled investment vehicle, one of these two options, ETFs mutual funds, whatever that you don’t have the opportunities to receive cash.
Josh Robb:
Yes. They can give you dividends and they pay it out in cash. Or you can have it automatically reinvested into new shares if you want to do it that way. Now, one of the things when we’re saying which one is better is when you look at the cost again, passive either mutual fund or ETF are cheaper than active. The expense ratio can be a distraction for some people, as they always are saying, I just want the lowest one. Show me the lowest one. Well, you get what you pay for. And so a lot of times you need to look at what is the net return I’m getting? What are the results of these two funds? If they’re similar funds, similar investments after the expenses, which one is consistently done better for me. And that’s what you want to invest in.
So, it’s not really, how much does it cost, but what do I get paying that cost, because it’s same as anywhere. If I’m going to go get a haircut and a $1 haircut and one’s a hundred dollar haircut, there may be a difference in what I get in those haircuts. And it may be worth paying a little more. Now, I don’t think I’d ever pay a hundred dollar haircut.
But there’s probably a difference in service. And so keep that in mind, expenses are there for a reason because there’s a lot of options out there. It does put some pressure on managers to make sure they keep their expenses low, or at least as low as they can to be competitive. So it’s not just like they can charge whatever they want and they have to buy it, because there’s probably another fund out there that can do something similar. So pay attention to that, but realize that that’s not the end all there may be times we’re paying a little extra for the expense, get you a better return in the long run.
Austin Wilson:
I’m thinking of the way that you can kind of do a check on that is you take your return and then you subtract off the expense ratio for various different investments over various different time horizons and choose what is most attractive to you from that perspective. And yeah, oftentimes I’m thinking of specifically fixed income is something that comes to mind of something where it might pay a little, it might be worth to pay a little bit more for someone with some really good expertise who really knows the ins and outs of certain areas of fixed income. And you may come out ahead further than the pretty high, probably expense ratio because that’s a lot of work. Where in equities, sometimes, active managers, aren’t going to outperform in different periods and that could put pressure on them to onsite investors to at least look at like a index style.
Josh Robb:
Yeah. You mentioned fixed income. I think it’s over 70% of active, fixed income managers actually outperform. And that’s because there’s a lot of opportunities with… Fixed income is giant. I mean the market there, when you think of the stock market, the fixed income dwarfs it, I mean, it’s huge. Yeah. And so there’s a lot of areas where a good manager can find opportunities to outperform a benchmark. And so you’re right. There may be times you say, “Hey, I’ll pay a little extra for this guy to do the research and stuff I don’t have time for. And I’m going to end up better off than I would have been on a passive fund.
[34:46] – The Key to ETFs & Mutual Funds
Austin Wilson:
Yep. Wow.
Josh Robb:
That’s a lot.
Austin Wilson:
That is some heavy stuff. And like Josh said, we think there are opportunities for investors to utilize both of these vehicles or not. You could just invest in individual stocks and individual bonds and be totally fine. So, there’s a lot of options, but we wanted to kind of walk through some differences and some similarities between the two, because these are thrown around almost interchangeably and there are some key differences. So-
Josh Robb:
And we will say too, in closing, the key is understanding what you own. If you don’t know what it is that you own, you need to make sure you find an advisor, somebody to help you because we’ve seen places where, and this is, I was just reading an article in one of my newsletters, it was talking about people who are owning leveraged ETFs, which we’ve talked about that in the past, where they multiply the result of whatever you’re trying to do, so an S&P 500 that’s three times leverage gets three times the results per day, up or down and people weren’t understanding, that’s what they own. So if the market goes well, “Hey, look, I’m doing really good”, but then when it drops, you’re going three times as far down. And so in general, make sure you understand what you own, because there’s a lot of funds and ETFs out there that do some crazy stuff, which are for sophisticated investors who have a strategy for that. So just make sure you understand what you own. It’s key.
Austin Wilson:
For sure. Well, as always check out our free gift to you. A brief list of eight principles of timeless investing. These are overarching investment themes meant to keep you on track to meet your long term goals. It’s on our website, check it out. It’s free. Josh. How can listeners help us grow this podcast?
Josh Robb:
Yes. So if you’re listening on Apple podcasts, please leave us a review wherever you’re listening to us, make sure you subscribe. So you get our most recent episode coming to you. We try to post these every Thursday. You can email us any ideas or questions to hello@theinvesteddads.com. And then if you know somebody who was asking questions about ETF mutual fund, make sure you share this episode with them.
Austin Wilson:
All right, well, thanks for being here this week. We’ll talk to you next Thursday.
Josh Robb:
Yep. Talk to you later.
Austin Wilson:
Bye.
Outro:
Thank you for listening to The Invested Dads Podcast. This episode has ended, but your journey towards a better financial future, doesn’t have to head over to theinvesteddads.com to access all the links of resources mentioned in today’s show. If you enjoyed this episode and we had a positive impact on your life, leave us a review, click subscribe, and don’t miss the next episode.
Josh Robb and Austin Wilson worked for Hixon Zuercher Capital Management, all opinions expressed by Josh, Austin or any podcast guests are solely their own opinions and do not reflect the opinions of Hixon Zuercher Capital Management. This podcast is for informational purposes only and should not be relied upon for investment decisions. Clients of Hixon Zuercher Capital Management may maintain positions in the securities discussed in this podcast. There is no guarantee that the statements, opinions or forecast provided here in will prove to be correct. Past performance may not be indicative of future results. Indices are not available for direct investment. Any investor who attempts to mimic the performance of an index would incur fees and expenses, which would reduce returns. Securities investing involves risk, including the potential for loss of principle. There is no assurance that any investment plan or strategy will be successful.
