KFC1101F
INVESTMENTS
(WRITTEN INDIVIDUAL ASSIGNMENT)
Compare and Contrast: Mutual Fund VS Exchange-Traded Fund (ETF)
NAME
: NUR IFFAH BATRISYIA BINTI SANI
COURSE
: FOUNDATION IN COMPUTER SCIENCE
STUDENT ID
: 24005570
STUDENT GROUP : CS1
INSTRUCTOR
: SIR AFZAL KHAN
DATE
: OCTOBER 11, 2024
1
TABLE OF CONTENTS
No.
Content
Page No.
1
Introduction
3
2
Risk and Return
4
3
Liquidity
5
4
Time Horizon
6
5
Costs/Fees
7
6
Suitability
8
7
Recommendation
9
8
References
10
2
Introduction
The purpose of this report is to evaluate the overall risk and performance of two common types
of beginner-friendly investments which are mutual fund and exchange-traded fund (ETF). By
taking into account the aspects of return value, liquidity, time horizon and costs associated with
the management process, it is easier to identify the suitability of each type and to make a
recommendation based on the respective investor’s end-goal.
Modern mutual funds were established long before ETF in response to the financial crisis of
1772-1773 in the Dutch Republic. They were created as a way for many investors to pool their
money and make investments together. By investing in a mutual fund, each investor will get to
own hundreds or more of different stocks all in one easy package in a single purchase.
On the other hand, an ETF is an open-ended investment fund that tracks the performance of a
specific underlying asset be it an index, a commodity or other suitable underlying security.
Similar with mutual funds, an ETF is also a type of pooled investment security that holds
multiple underlying assets, rather than only one. The first ETF was introduced by State Street
Global in 1993 known as SPDR S&P 500 ETF, which tracks the S&P 500 Index.
3
Risk and Return
Generally, potential risks imposed by mutual funds would not be significantly different from the
exchange-traded funds (ETF) as both are similar in terms of allowing better diversification.
Diversification is the practice of spreading investments around so that the investors’ exposure to
any one type of asset is limited. It's designed to help reduce the volatility of their portfolio over
time.
However, a major difference between these two types is that mutual funds are managed actively
by professionals while most ETFs are passively managed. Passive ETFs generally have strong
historical long-term returns as they would try to match the return of the market. This passive
strategy could pay off long-term, considering that the S&P 500 has earned a little over 10% a
year since 1928, although past performance cannot fully guarantee future results.
While active ETFs and active mutual funds try to earn higher returns than the market, analysts
found only 1 out of 4 active funds out-performed the market over a 10-year period ending in
June 2022.
4
Liquidity
Liquidity of each type of investment is closely related with their respective trading access. An
ETF would be considered as having higher liquidity than that of mutual funds because ETF
shares can be bought and sold at any time throughout the day, similar to stocks. Also like
stocks, an ETF’s price can change during the day based on the performance of the fund’s
investments.
Unlike ETF, a mutual fund trades only once a day after the market closes for the price set at 4
p.m. ET. At that point, the fund manager will also release the updated mutual fund share price
based on the day’s market results.
However, this will not make much of a big difference for most long-term investors.
5
Time Horizon
An investment time horizon refers to the time an investment is held until sold. Time horizon can
be classified into short-term, medium-term and long-term. Time horizons are largely dictated by
investment goals and strategies. For example, saving for a down payment on a house, for
maybe two years, would be considered a short-term time horizon while saving for college would
be a medium-term time horizon, and investing for retirement is a long-term time horizon. The
longer a time horizon, the riskier a portfolio will tend to be. While the shorter the time horizon,
the more conservative, or less risky, the portfolio that may be adopted by investors.
Longer-term investors could have a time horizon of 10 to 15 or more years, but intraday price
movements in ETFs could induce them to trade unnecessarily. Due to the 24/7 tradability of the
ETF and the displayed market price that is ever-changing, investors tend to fall into the pit of
impulsive buying and selling assets whenever the price fluctuates. Therefore, the typical holding
period of ETFs could possibly be shorter than that of mutual fund assets.
6
Costs and Fees
Mutual funds imposed higher fees due to the involvement of professional managers. In return
for managing the investors’ money actively, mutual funds charge an annual fee of one to two
percent of their account balance every year. Generally, the high expense ratio of mutual funds is
driven by costs such as the management fee, fund accounting and trading expenses, and load
fees related to their sale and distribution.
To illustrate, at 2% if an investor invested RM10,000 in a mutual fund, RM200 of the total goes
straight into the fund manager's pocket. And even if the manager makes poor investment
decisions and causes the account balance of the investor to drop the next subsequent year, the
investor will still get charged 2%. Therefore, it is possible for investors to end up with less
money than they started with while the fund manager would still get paid thousands or millions
for their services.
ETFs, which are passively managed, tend to have significantly lower expense ratios than
actively managed mutual funds. With ETFs, investors could owe a trading commission, a flat fee
each time investors buy or sell, depending on the broker.
Moreover, as passively managed portfolios, ETFs have limited capital gains tax which makes
them more tax-efficient than mutual funds. Mutual funds require distribution of capital gains to
shareholders if the manager sells securities for a profit. This distribution amount is made
according to the proportion of the holders' investment and is taxable. If other mutual fund
holders sell before the date of record, the remaining holders divide up the capital gain and thus
pay taxes even if the fund overall went down in value.
7
Suitability
Generally, short-term investors who prefer being able to trade like stocks anytime they want
would be most suitable with the ETF. This is because they have the ability to observe the
change in market price which is frequently updated throughout the day.
On the other hand, a mutual fund is suitable for longer-term investors with a clear end-goal and
does not get influenced easily by market price. This can also be applied to investors that are not
able to track the market often and prefer to seek professional help.
8
Recommendation
In most cases for a first-time investor, their initial investment goals would probably be to go for
the less-risky and more popular approach which is the ETF.
An ETF can be bought in an amount as little as a single share and even fractional shares in
some cases. This small minimum requirement allows new investors to start their investing habit
with a small sum.
Another crucial factor to consider is that most new investors that use accounts other than
retirement accounts would most likely consider the amount of tax that will be imposed onto their
investments. ETFs are proven to be more tax efficient compared to traditional mutual funds
since holding an ETF in a taxable account will generate less tax liabilities than holding a
similarly structured mutual fund in the same account.
The statistic shown above proves that the ETF has been gaining popularity rapidly over mutual
funds.
9
References
David J. Abner, (2011). ETFs vs. mutual funds: Tax efficiency.
https://www.fidelity.com/learning-center/investment-products/etf/etfs-tax-efficiency
Joshi, G., Dash, R. Exchange-traded funds and the future of passive investments: a bibliometric review
and future research agenda. Futur Bus J 10, 17 (2024). https://doi.org/10.1186/s43093-024-00306-8
10