ETFs, mutual funds, or both?

Vanguard investing experts Rich Powers and Josh Hirt discuss the differences and similarities between these two investment vehicles.

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Talli Sperry: So Rich why don’t we go ahead and answer one of our first questions that was submitted by our audience, and that is, “What is an ETF?”

Rich Powers: That’s the perfect place for us to start. Let’s first break down the acronym itself. ETF stands for “exchange-traded fund,” a fund that trades on the exchange. So think of it as a mutual fund that is available to be purchased either on the New York Stock Exchange or the Nasdaq market. I think all of us are pretty comfortable and familiar with mutual funds. And the question might be, “Why are we talking about ETFs?” I think that the big answer for that is, “There’s a lot of interest in ETFs, particularly over the last 10 years or so.” What’s probably not well known is [that] ETFs are almost 25 years old. The first ETF in the U.S. was launched in 1993. So, it’s a pretty familiar vehicle in the marketplace, but it’s only in the last 10 to 15 years where more and more investors have come to appreciate that, largely because early days for ETFs, they were focused as investment vehicles for institutions, but now ETFs are being used by a wide array of investors. In fact, we’ve observed a meaningful uptake in investment across the direct retail investor, financial advisors, and institutions. We have a chart, actually, that speaks to the growth of ETFs over the last couple of years.

Talli Sperry: Could we bring that up? Let’s bring that up for our audience.

Rich Powers: What that chart actually speaks to is the rolling six-month cash flow into ETFs over the last 20 or so years. And what you observe over the last decade or so, but particularly in the last two to three years, is a meaningful spike in cash flows, and it speaks to this idea that ETFs are becoming more mainstream, more ubiquitous, and at this point, $3 trillion of investor assets here in the U.S. are invested in the over 2,000 ETFs in the marketplace.

Talli Sperry: So these are really time-tested products; they’ve been around for quite a while; people seem to be using them fairly frequently; they’re pretty stable products even though they might be new to many of us. Is that correct?

Rich Powers: I think that’s a great way to characterize it. And in many ways, an ETF is, effectively, the same thing that we all know and love with respect to mutual funds. ETFs have some additional features that make them different but, largely, the investment product that most Americans use to save for retirement or for education or for some other goal, ETFs kind of are built off that chassis.

Talli Sperry: That’s great. That’s good. So we’re already more familiar than we might think. Thanks for the insight, Rich.

Let’s take a quick moment and see how our audience responded to our first poll question. So when we look at “Which of the following best describes your understanding of ETFs?” we see that most of our audience, about 58% of them, are somewhat knowledgeable. And we’ve got about 36% that are not knowledgeable at all. I’m actually surprised that some of our audience, such a high percentage, are somewhat knowledgeable. Would you say that this mix is pretty consistent with what you hear?

Rich Powers: I think so. My team, along with some of my colleagues elsewhere, have studied this, and in terms of the adoption curve of ETFs, as I mentioned earlier, institutions were the earliest users of the product; and financial advisors, for a myriad of reasons, started to adopt them; and it’s only within the last 10 or so years where the individual investor has said, “This is an interesting product. It could have some utility for me as I’m building a portfolio.”

Talli Sperry: That’s great. So, as we continue, let’s ask our audience another poll question. And this one, for those of you who are familiar with ETFs and even for those of you who aren’t, because sometimes we do find people invest in products they may not know as well, and that question is, “Are you currently invested in ETFs?” And our answers are simple, “Yes,” “No,” or “No, but I’m considering them.” So, again, please respond now and we’ll get to your answers in just a few minutes.

Okay, so let’s take another one of our presubmitted questions right now and then we’ll see how our viewers respond. So, Josh, I’m going to give you this one. Actually, you know what? Rich, I’m going to give it to you. So let’s compare ETFs and mutual funds. I paused a little bit because you got into that just a second ago, but if you could maybe give us the top two or three features that are different, that would be helpful.

Rich Powers: Sure. Before I do that, if you don’t mind, I think an analogy might work here. So think about vehicles, right? You’re going to go out and buy a new SUV. There’s a myriad of different SUVs you can consider. Some of those SUVs have certain features that you might like and want to consider, but largely they’re offering the same thing, which is transportation somewhere, comfort. And so, I think of mutual funds and ETFs kind of falling in the same basket. ETFs and mutual funds are governed by the same regulatory structure. So the SEC is, in terms of how they think about looking after ETF investments, very familiar, very similar to what they do for mutual funds.

And then, too, mutual funds and ETFs are both pools of securities that help an investor reach some type of investment objective. So that pool can be of stocks; it can be of bonds; it can be a combination of both. So there’s those similarities that a lot of us are familiar with.

The differences really fall into three buckets. One is that with an ETF, you’re buying that security on an exchange. So think of the New York Stock Exchange or the Nasdaq. In contrast, with a mutual fund, often times you’re opening an account with a firm like Vanguard and going directly to them to buy the portfolio.

Two, for most ETFs, they follow an index strategy. About 99% of all ETFs today follow some type of index strategy, whereas the majority of mutual funds out there actually follow an active strategy, where a manager or team of investors are trying to outperform the stock or bond market.

The last key difference between ETFs and mutual funds would be that with an ETF, you buy and sell that security at prices between 9:30 [a.m.] and 4 p.m., [Eastern time,] when the stock exchange is open, so you can buy an ETF at 9:50 [a.m.], buy it at 11:30 [a.m.], buy it at 12:30 [p.m.]. With the mutual fund, there’s only one price at which you can transact, and that’s at the 4-p.m. market close.

Talli Sperry: But you can still buy them throughout the day, right? Even though the price stays the same.

Rich Powers: Right. With an ETF, you can buy at different prices. For a mutual fund, you can submit your order at any time of day. The price you receive will be the price that struck at 4 p.m. that day.

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