At the Money: Mutual Funds vs. ETFs with Dave Nadig, Financial Futurist for Vetta Fi (December 13, 2023)
What’s the best instrument for your investments? Mutual funds or ETFs? On today’s edition of At the Money, Barry Ritholtz speaks to Dave Nadig about the pros and cons of these two investment vehicles. Listen to find out which is right for you.
Full transcript coming shortly…
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About this week’s guest:
Dave Nadig is the Financial Futurist for Vetta Fi, and ETF Trends and ETF Database. He has been involved in researching, reporting and analyzing the investment management industry for more than 20 years.
For more info, see:
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Transcript: Mutual Funds vs. ETFs
Barry Ritholtz: For nearly a century, when investors wanted a professional to manage their stocks or bonds they turn to a tried and true vehicle: Mutual funds.
But over the past few decades the mutual fund has been losing the battle for investors attention. Primarily to exchange traded funds but also to things like separately managed, accounts and direct indexing.
Does this mean we’re at the end of the famed mutual fund?
[Audio collage: 401K’s and mutual funds mutual funds and exchange traded funds mutual funds and other investments everything is done on mutual funds in most mutual fund many mutual funds and index funds that are owned by consumers]
Barry Ritholtz: I’m Barry Ritholtz and on today’s edition of at the money we are going to discuss what fund wrapper is best for your capital. To help us unpack all of this and what it means for your portfolio, let’s bring in Dave Nadig. He is financial futurist at verify and a well known ETF industry pioneer.
So Dave. I’m gonna throw another of your quotes back at you “If the mutual fund was invented today it wouldn’t get regulatory approval.”
Dave Nadig: Absolutely not!
Barry Ritholtz: Explain.
Dave Nadig: Well the key thing about a mutual fund that’s different from an ETF is primarily how the money gets in and out and then how it’s taxed. The reason mutual funds are inherently at this point an inferior structure to ETF’s for almost everything is how that money gets in and out.
So when you put money into mutual fund Barry you send money virtually to say Fidelity and then they take that cash and then they go buy a bunch of stocks. When you want to take your money out, they say “Oh, Barry wants his money back” and they sell a bunch of stocks and they give you your cash.
It can be a little bit more complicated than that, but that’s the
Barry Ritholtz: That’s the core aspect that’s the you send them cash and they go out to the marketplace and make purchases on your behalf within the structure of everybody else in that exactly
Dave Nadig: That sounds great and it’s a fantastic structure it’s actually been going back since the 1400s and the Dutch East India company right that kind of pooled mutual structure very straightforward. The problem is when you decide to sell the tax bill for any gains and selling all those stocks so you can get your $100 million back – that tax bill notionally gets applied to the entire pool.
Now it’s not as bad as it sounds I don’t have to pay taxes that I never get back just because Barry sold however I will have to deal with that this year left adjust my basis I will get a distribution, I’ll get a taxable gain that shows up on my IRS report
Barry Ritholtz: Even though you didn’t sell
Dave Nadig: Without selling a darn thing so anybody who’s owned a mutual fund in a taxable account knows this you get a distribution you didn’t sell anything some of that’s dividend from stocks or coupons from bonds but some of it’s just “Hey we bought and sold some stuff, we have to pass that out every year” that’s the rule the IRS has and by passing that out you mess with every holder of that fund’s taxes for that year. And they take away a timing benefit because you have to recognize that this year even though somebody else sold.
Barry Ritholtz: So now do a compare and contrast with an ETF that is different in terms of capital gains distributions.
Dave Nadig: The primary difference is that the ETF is rarely buying and selling anything on behalf of the whole pool. When new money comes into the fund because Barry, you went out and bought $100 million, you caused it to be a little more expensive. That makes these other folks (these authorized participants that you never have to worry about) do the actual creation of new shares of the fund you want with the issuer. They do that by buying all those stocks and just handing them over to the fund. Same thing happens in reverse. Because no “sale happens” with big air quotes around it. It’s all happened in kind. The IRS doesn’t treat that as a taxable event
Barry Ritholtz: Explain “In Kind” – in other words with the mutual fund, I’m literally sending — here’s $1000 and they say we have 100 stocks and go out and buy $1000 worth of stocks. Literally it’s that simple. When you say in kind transaction how is it different with an ETF?
Dave Nadig: Well from the individual investors perspective you just buy an ETF like a stock. So it’s really simple you buy it you sell it easy-peasy.
Barry Ritholtz: So then how do these funds get created if I’m buying something that’s trading every day.
Dave Nadig: If enough people are buying at the same time, the price of the ETF will go up a little bit. When it goes up enough so that it’s actually a little bit overvalued compared to the underlying basket of stocks, these arbitrageurs step in and they create those shares (and they’re allowed to there’s a whole system for that that is an individual investor you don’t have to know about) but the end result is the tax liability gets washed, it gets pushed forward into the future, so your SPY holdings you’re not going to get capital gains distributions. You might still get dividends – that’s still going to happen – but your capital gain is going to be based on when you choose to sell it. So if you buy it at 400 and sell it at 500, you have a personal $100 gain that you report on your taxes. It’s very clean, it’s very simple, and it’s tax efficient and tax fair.
Barry Ritholtz: So that that seems to be one reason why ETF’s are attracting a lot of capital that previously were either flowing to mutual funds or as we’ve seen come out of mutual funds and had headed to ETF’s. Before we get too enthusiastic about exchange traded funds what are the downsides of these?
Dave Nadig: Well you do have to know how to trade. And if you’re not comfortable buying and selling Microsoft stock, you should not be out there buying buying and selling SPY, the S&P500 spider. Because it has the same issue in the sense that there’s a price you pay to get it, and there’s a price you pay when you sell it and there’s a gap in that and if that gap isn’t very wide that spread is very wide then that’s friction on your on your investment return. So that’s it’s sort of a hidden cost to trading. So I always say you need to be comfortable with trading hygiene right you need to understand the basics of how to get a trade in, how not to get messed up there. Then it’s really straightforward that’s the primary issue.
The other thing I think investors can get a little over their skis on is because we have so many ETF on the market now and the structure is incredibly flexible. You can get access to all sorts of stuff that may or may not actually belong in your portfolio you want triple leveraged inverse oil futures, you can get that in an ETF wrapper you probably shouldn’t
Barry Ritholtz: Right to say the very least so so if the downside to owning mutual funds is these phantom capital gains that suggests that if you have a tax deferred account – 401K an IRA, 403B anything like that – mutual funds probably can live very comfortably in those sort of accounts.
Dave Nadig: Absolutely. In my own personal portfolio I use a whole bunch of index mutual funds that happen to be available in those retirement plans and they do a great job. There’s no reason not to have them there, and in fact there are some reasons why mutual funds are better in that environment.
Most people who contribute to their IRA or their 401K don’t think about it in shares, they think about it in dollars. X percent of my paycheck now, I’ve got $380.00 more in my 401K –
you want that $380 split into whatever funds you had. But if you were doing that in ETF you have to buy an individual share which might be $25 or $125.00 for one share. It’s very noisy you’re not going to be able to make your allocation perfectly.
Mutual funds don’t trade that way they trade in fractional shares to the 5th decimal point. So even if you’re trying to get a dollar to work you can split that dollar across five different funds.
Barry Ritholtz: Wow, that that’s interesting. So is it a little premature to say that we’re looking at the death of mutual funds? Is it more accurate to say these things are evolving and ETFs and mutual funds are all serving different purposes?
Dave Nadig: I think that’s the world we’re headed toward the the old phrase I like uses you know different horses for different courses you know put the horse racing bets on it you know there are some use cases particularly around retirement as you highlighted.
The other sort of edge case in mutual funds is sometimes you want to close a fund. If you’re a small cap Special Situations manager you may not be able to run $10 billion the way you could run $200 million so you caps you capital 200 and you close it. In fact, a lot of the best performing mutual funds out there year after year are closed to new money and that’s because somebody has some sort of edge usually in an active management context and they can only express that edge at a certain size.
You cannot do that in an ETF, you can’t close an ETF for new money because that whole mechanism we just talked about about buying and selling it in the market that’ll get haywire because now you can’t make or get rid of any of them.
Barry Ritholtz: So let’s tie all this up together: Mutual funds have been around for practically forever; the 40s act 1940a act is the legal documents that are created what is essentially the modern mutual fund.
Typically what we’ve seen over the past few decades is the rise of a lot of alternative wrappers to purchase stocks and bonds. As an investor, you need to think about what sort of holding you have in order to figure out where to locate those assets if you’re in an active mutual fund that has a lot of transactions and a lot of phantom capital gains taxes well that’s something you want in a 401K or an IRA.
If on the other hand you’re holding something in your portfolio that’s not tax deferred hey that’s the perfect opportunity for an ETF and a lot of fun companies will offer you both whatever you want you want the S&P 500 you get that ETF you can get that in mutual fund just about all of the big companies offer parallel mutual funds and ETF these days be careful about where you put those funds it’ll make a big difference to your tax payments and your bottom line.
You can listen to at the money every week finding in our Masters in Business feed at Apple podcast each week we’ll be here to discuss the issues that matter most to you as an investor
I’m Barry Ritholtz you’ve been listening to At The Money on Bloomberg radio.
