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ETFs vs. Unit Trust / Mutual Fund: What's the Difference?

Potayto, Potahto.

Tomayto, Tomahto.

Is an “Exchange Traded Fund” and a “Unit Trust Index Tracker Fund” just the same thing with a different name?

Let’s clear up this confusion.

Luckily, I can talk about Index Trackers ALL day because these are some of my favourite things to invest in.

If you aren’t yet investing in them, go here to download a free guide to Investing with Index Trackers.

Index trackers are these juicy, amazing investment vehicles. 

The easiest, lowest-cost way for you to own and control an amazing selection of shares in companies all over the world – so your money gets working for you and not for the financial industry. 

One of the most frequent questions I get asked about index trackers is this…

❝ Ann, what is the difference between an ETF, an exchange
traded fund and a unit trust / mutual fund index tracker? ❞

This is a super question and something that really gets people stuck.

In this video I unpack the difference so in no time you can move forward and know which of these two types of index trackers you should be using in your investments and why.

 

 

What is an Index Tracker Fund? 

An index tracker fund is a basket of shares in different listed companies.

Actually, that’s just a description of an investment fund. 

What defines an index tracker fund is how the shares that go into the basket are selected.

Index Tracker funds seek to replicate the holdings (the shares in the index) and performance of a specific market index. That means that the shares inside a tracker fund basket are selected on the basis of the market index the fund is replicating and not based on a fund manager’s selection.

Investing in index tracker funds is also called passive investing.

Initially, index funds were introduced to provide investors a low-cost investment vehicle that allowed for exposure to the many shares included in a market index. 

The primary advantage of passive investing using index tracker funds is the lower expense ratio (lower ongoing charges) of an index fund and the fact that the majority of investment fund managers fail to beat broad market indexes on a consistent basis. In plain English, tracker funds outperform most actively managed funds.

Popular indexes for U.S. market exposure include the S&P 500, Dow Jones Industrial Average and the Nasdaq Composite. For UK market exposure it’s the FTSE, for Europe it’s the Eurostoxx, for Hong Kong it’s the Hang Seng, for Australia it’s the ASX, and so on.

Both ETFs and unit trusts / mutual funds are types of index trackers – they’re slightly different products doing very much the same thing.

How Do You Invest In Index Tracker Funds?

The first thing you need to do is to set up an account on a digital investment platform.

The proliferation of online platforms and apps has made even this first step bewildering!

In fact, the questions of “which platform” and “what kind of index tracker” are related – some platforms are better for ETFs and others are better for mutual funds and unit trusts. 

Once you’ve got your account open, you'll decide on the portfolio you want (i.e., the different markets you want to track). You may even already know that you want a “home” market tracker or a “developed markets” tracker or an “emerging markets” tracker, but nearly all platforms offer these different options so you don’t need to decide that upfront.

So there are these different products that do much the same thing – what type of index tracker fund should you invest in?

What Type of Index Tracker Fund Should You Choose? 

Your choice will be investing in an ETF, an “Exchange Traded Fund” or a Unit Trust Fund (also called a Mutual Fund). 

What the bleep! is the difference?

Both unit trusts / mutual funds and ETFs hold portfolios of assets: stocks and/or bonds, property, and occasionally something more exotic, like precious metals or commodities.

Both unit trusts / mutual funds and ETFs must adhere to the same regulations which cover what they can own, how much can be invested in any one share, and how much money they can borrow in relation to the portfolio size, and much more.

Both unit trusts / mutual funds and ETFs have a net asset value (NAV) per unit / per share. This is the total value of the fund (the portfolio of assets) divided by the number of shares or units that have been issued.

Beyond these requirements, their paths go different ways. 

Understanding an ETF

As the name suggests, ETFs (Exchange Traded Funds) trade on exchanges (stock markets) in the same way that shares in individual listed companies are traded.  

You can buy and sell ETFs at any point during a trading day at whatever the price is at the moment of the trade, based on market conditions, not just at the end of the day.

The price of  ETFs depends on supply and demand, but arbitrage means that the exchange price is never more than fractionally different from the NAV share price (i.e., the underlying value of a share of the portfolio).

The ETF providers themselves want the price of ETFs (set by trades within the day) to align as closely as possible to the net asset value of the fund (or portfolio). To do this, they adjust the supply of shares by creating new shares, redeeming old shares, or actually trading themselves – which is first base. Price too high? ETF providers will create more supply to bring it back down. Price too low? ETF providers will buy in the market to drive price up. All of this can be executed with a computer program, untouched by human hands.

Unit Trust / Mutual Fund

When you put money into a unit trust / mutual fund index tracker, the transaction is not with a stock exchange but with the company that manages the fund – in other words, with a company like Vanguard, HSBC, Fidelity, L&G or BlackRocks – either directly or via your digital investment platform.

The purchase of a unit trust / mutual fund is executed at the NAV (net asset value price) of the fund based on the price when the market closes that day (or the next if you place your order after the close of the markets). When you sell your shares, the same process occurs, but in reverse. For long-term investors (and that’s what we are) this doesn’t really make much of a difference.

Unit trusts / mutual funds and ETFs are all open-ended. This means that the number of outstanding shares (or units) can be adjusted up or down in response to supply and demand every day.

As money flows into or out of a unit trust / mutual fund each day, the managers have to deal with these flows in the portfolio. If there’s a net inflow they have to buy shares. If there’s a net outflow and not enough spare cash they have to sell some holdings. This means there may be more transactions within the portfolio of a unit trust / mutual fund compared to an ETF (this may not directly affect you as an investor but it’s worth knowing).

Practical Differences

Apart from the difference between NAV share/unit price and exchange price (for ETFs), most of the above makes little difference to you as the investor. So what are the practical differences?

Index-tracking ETFs often have lower ongoing expenses (called Ongoing Charges, OTCs, or Total Expense Ratios, TERs) than index-tracking unit trusts / mutual funds. In large markets like the UK and the US, this difference is rapidly closing, but elsewhere like Europe, South Africa, Australia, etc, ETFs still generally have the advantage of lower ongoing costs. This means more of your money works for you and less goes to the financial industry. 

This cost differential relates to the mechanics of running the two kinds of index tracking funds and the relationships between funds and their shareholders. In an ETF, because buyers and sellers are doing business with one another via the exchange, the fund house and its managers have far less to do. 

Ten years ago it was usually best to buy ETFs through a stockbroker and mutual funds / unit trusts from the fund manager (the fund house) or a fund platform. But today the line between “online brokers” and “investment platforms” has become blurred. The only way to choose the product (ETF or unit trust/mutual fund) is to look at the cost structures and other benefits of the digital investment platforms available to you. Also, you have to review your location options – different kinds of platforms operate in different parts of the world, sometimes because of regulatory differences.

Since ETFs are bought and sold on the exchange there are costs associated with each trade. These are once-off costs you incur on the buy and the sell, but they can quickly eat into your investment especially when you are investing in small regular amounts.  As a rule of thumb, only use ETFs when you are buying in lumps where the cost of the trade is less than 1% of your investment amount. For smaller investments you could consider a digital platform that specifically provides access to ETFs and unit trusts/mutual funds. Some of these may change small ongoing fees (either a fixed account fee or a small percentage of your holdings deducted periodically).

Some digital platforms like Degiro in Europe offer a massive selection of trade-free ETFs which enable you to do regular, smaller investments in ETFs (as these costs are no longer a factor). And a platform like etfSA in South Africa bundles the buying of ETFs for their investors to lower trade costs but charges an ongoing fee. 

Major index funds track their underlying indexes very closely regardless of whether they are ETFs or unit trusts / mutual funds. The decision – whether to buy ETFs or unit trusts / mutual funds and what platform to use – usually boils down to comparing the long-term benefit of lower ongoing charges to paying more upfront costs to enter into the investment.

The Bottom Line

Given the differences between the two kinds of funds, which one is better for you? 

It depends – mostly on the options available to you in your country and how much you’ll be investing with each trade. 

For small regular investments in the UK and US – simply find a set of great unit trust / mutual index tracker funds with low ongoing charges or no-trade cost ETFs, use a low cost platform, set up your automated regular investing and get on with your life.

For small regular investing in South Africa – use a platform like EasyEquities (both an online stockbroker, in old terms, and a platform) or etfSA (a fund platform) to benefit from low trade costs and low ongoing charges. Set up reminders or automated regular investing and get on with your life.

For small regular investing in Europe, find an ETF platform like Degiro that offers you a great selection of no-trade cost ETFs and various unit trusts / mutual funds. Set up reminders for your regular investing and get on with your life.

For bigger lump sum investing, go with the same set you have for your regular investing and use a low cost digital investment platform.

Most of all, remember:

  • being in the market is way more important than trying to time the market; and 
  • consistent regular investing will always outperform haphazard investing.

Why not continue the wealthy conversation on the Facebook community page (it’s free to join) and see what others are saying? We’d love to know:

  • If you are investing in index trackers, what type are you investing in?
  • If you aren't investing yet, if you don't yet have your regular stock market investing set up and your index tracker portfolios in place, tell us when you're going to get started and what’s holding you back… because you must have this juicy asset class working for you. 

Remember, your freedom is created just one step at a time and that's all you need to do. Keep taking each step and let index trackers help you along your way.

With huge love

Ann

PS Get the free ebook “Expand Your Dough” to learn how to get index trackers working hard for you.