In this episode, Matt and Mike discuss all the nitty-gritty details of Exchange Traded Funds (ETFs) and Mutual Funds. What are these funds? How are they similar? How are they different? But most importantly: Which should you choose?
Tune in as we discuss:
- Why some investors were hit with a big tax bill for holding a mutual fund!
- Why you should invest in ETFs in your brokerage accounts.
- What are A, B, and C class shares of mutual funds?
- What is an index fund?
- The difference between an active and passive fund.
- Why are mutual funds and ETFs taxed differently?
- Can you exchange a mutual fund for an equivalent ETF?
Find out more about Mike at https://www.mortonfinancialadvice.com and connect at https://www.linkedin.com/in/mwsmorton/
Transcript
All right.
Matt:So our podcast listeners, we're continuing this discussion, our radio listeners.
Matt:We hope we got you back onto the podcast.
Matt:Let me just ask about a couple of terms that we've thrown around and
Matt:that people throw around in general.
Matt:They about sometimes they, talk they definitely do about mutual funds.
Matt:Most people have heard of mutual Some people have heard of ETFs
Matt:and now they definitely have, and we talk a lot about index funds.
Matt:W what are, let's just talk about the index.
Matt:Fund part of this, how are they the same or different than ETFs and mutual
Mike:Yeah, that's a great question.
Mike:I get this the time.
Mike:ETFs are index funds,
Mike:or wait, are they mutual funds?
Mike:Or people just use the word funds, now you have a good understanding,
Mike:a good start to mutual.
Mike:Versus ETFs.
Mike:Okay.
Mike:What are index funds?
Mike:What are index.
Mike:funds?
Mike:Index funds are a fund that tracks index.
Mike:Alright.
Mike:And an index.
Mike:You can define it any way you want.
Mike:right, Matt, I could have fast food chain index.
Mike:I'm going to hold equal weight of McDonald's burger king
Mike:Chick-fil-A and taco bell.
Mike:And that's mine.
Mike:And now I, now someone that's my index and it's easily defined.
Mike:All right.
Mike:That's that is a prerequisite for an index.
Mike:You have to able to define it algorithmically, easily defined,
Mike:and then you could create a fund that tracks that index.
Mike:Mine is very simple.
Mike:It's for companies equal weight, 25% of each in a fund.
Mike:So Matt, you can go ahead and launch.
Mike:Called the the Matt fast chain fond based on the Morton fast food index.
Mike:And it.
Mike:just holds those four things.
Mike:Super easy peasy.
Matt:So an index is just a, it's a sample from a particular sector
Matt:or it's a sample of anything.
Mike:in, yeah.
Mike:Think of it this way.
Mike:It's really just a well-defined set.
Mike:Within the investible So S and P 500 500 companies in the U S total us
Mike:stock market, 30, 33,000 companies here in the U S we could do the
Mike:Australia total Australian market.
Mike:Okay.
Mike:So those are all examples of an index that are easily defined.
Mike:you know what they are?
Mike:And then you could have a fund that tracks that index.
Mike:Now it can literally be invested in what the index or it can track it.
Mike:Very closely by holding 80% of it will get very close tracking say, and there's
Mike:all kinds of mathematics behind all that.
Mike:Okay.
Mike:Index fund is just simply a fund that tracks an index are well-known ones,
Mike:total us stock market, total international markets, , the and P 500, right?
Mike:Those kinds of things.
Mike:Those are all indexes.
Mike:Now index fund is a fund that tracks index.
Mike:It could be an ETF exchange traded.
Mike:Where it could be a mutual fund.
Mike:So it could be either one
Matt:And.
Matt:An index fund it.
Matt:One of the of it is that if it's an index, it's just going to track
Matt:whatever you've put in that index.
Matt:I whole S and P it could the whole stock market.
Matt:It could know entertainment companies.
Matt:It could construction, whatever it is.
Matt:So since it set up.
Matt:You don't have do a lot that point.
Matt:You it's, not like a mutual fund where it's like, all right, what do
Matt:we think is a good investment today?
Mike:All right Hold a a sec, because see you just work you're thinking like
Mike:most people out there, I love a mat.
Mike:It's not like a mutual fund.
Mike:That's going to be actively managed, but remember an ETF is a fund.
Mike:It could be actively managed as well.
Mike:So it doesn't have to be mutual.
Mike:So let's talk about active versus passive.
Mike:We just define index fund and you're exactly right.
Mike:Index funds are very passive once I've defined what it is.
Mike:There's not a lot of work to it.
Mike:You have to create a fund that tracks it, not super hard using computers these
Mike:days, and you're up and running and you can work with a small team to do that.
Mike:So we call that very passive, passively managed.
Mike:It's just managed to whatever that index.
Mike:Okay.
Mike:Active is where we're making bets.
Mike:Hey, I think the energy sector is going to be better than the discretionary
Mike:consumer sector the next six months.
Mike:So I'm going to overweight my allocation to that sector.
Mike:And then we'll reevaluate in six months.
Mike:So now I've got a of researchers.
Mike:I'm a star manager.
Mike:And it more to do that I'm making active bets so that the fund
Mike:usually has a expense to it.
Mike:there's more involved and we're making active bets on what I predict
Mike:future to be, to get outsized returns is the whole point again though.
Mike:All right.
Mike:So there's my team.
Mike:I could launch that as a mutual fund.
Mike:That's been typically in the past because they a longer history,
Mike:but I can also launch as an ETL.
Mike:I can have actively managed ETF and going to see more and more of these.
Mike:So just be aware that you to know what you're investing in, whether it's a
Mike:mutual fund or an ETF, just understand it's the S and P or the total us
Mike:or the energy sector, or it's star manager or this particular slant to it.
Mike:That's more actively.
Mike:manage.
Matt:So you could have a mutual fund.
Matt:You could have an ETF, you could have a mutual fund that's actively managed.
Matt:You can have a mutual fund.
Matt:That is an index that is relatively passive.
Matt:You could have an ETF that is relatively passive or.
Matt:Relatively active.
Matt:So you have all these flavors and we've talked a lot about, there are
Matt:some , minor differences terms of when settled and whether they're
Matt:there they're traded within the day.
Matt:And whether, they have the same value as the underlying assets,
Matt:but what does it mean investors?
Matt:What's the difference to me?
Matt:Like why do I care about these diff
Mike:Yeah.
Mike:And I will mention one other thing I'm gonna answer your question.
Mike:I love the way you put that, could have this thing or that thing, it could be
Mike:this way or this way, get ready because ETFs are now holding futures contracts.
Mike:They're holding options inside the ETF wrapper.
Mike:So who your $1,000 you can buy the upside of the total us stock market,
Mike:but be protected on the downside.
Mike:a put option inside the ETF wrapper.
Mike:Okay.
Mike:So get ready for these only triple levered, but also what we call.
Mike:buffered, Where you're PR you're getting up to 10% of the upside, but
Mike:protected on the downside in these ways.
Mike:So it's getting very complicated, what people are launching
Mike:inside the wrapper of an ETF.
Mike:Throwing that out there for the listeners to get
Matt:All right.
Matt:Look, if going to throw something out, I I don't know, throw something Let me tell
Matt:you, we're going to do a show about this.
Matt:We're going to do a show about this because my sense is things
Matt:get more and more complicated?
Matt:It advantages people who are on the inside have a lot of
Mike:Advantage wall street
Matt:And it's not as that more complex and you have to understand
Matt:all the legalees and Latin, it's not necessarily advantages to you,
Matt:but anyway, let's talk about what matters to you and me and people like
Matt:us in terms of these differences.
Mike:so I'm just going to highlight one thing and then get into that.
Mike:The, remember the difference, one of the differences between ETFs and mutual.
Mike:Mutual funds settle at the end of day.
Mike:And I told you, they settle on their nav.
Mike:All Right.
Mike:Which is , , the net asset value, the prices of all the underlying stuff.
Mike:So in mine, I had those for, a fast food chain.
Mike:So at the end of the day, they stopped trading on the open
Mike:market I can look up the exact price, the last trade of each one.
Mike:And that is what my mutual.
Mike:fund Value is so it set at the end of the day.
Mike:And then Matt, you invested 5,000 bucks and you get exactly $5,000
Mike:worth of those four things underneath.
Mike:Okay.
Mike:Net asset value.
Mike:Whereas if buy them in the stock, market's going up and down up
Mike:and down and if you a a market price, you're just buying that ETF.
Mike:The ETF version of my.
Mike:four fast food chains is going up and down throughout the day.
Mike:And if you invest 5,000, you go get that spot price at that time.
Mike:different ways they work now, why is this important for investors?
Mike:We started the show with that capital gains problem.
Mike:All Right.
Mike:That you could get hit with capital gains, even though all you did
Mike:was just invest into a mutual.
Mike:The
Mike:reason why let me talk a little bit about how I told you how the mutual funds work.
Mike:The nav ETFs.
Mike:On the other hand, Matt in 5,000 bucks, my ETF has to issue
Mike:$5,000 of shares over to Matt.
Mike:The way I do that is on the ETF guy and I give him the ETF shares, but I've
Mike:got to buy the other four underlying.
Mike:Stocks I have a partner who does that?
Mike:He's called the authorized participant.
Mike:Okay.
Mike:So he's my friend, he's partner.
Mike:And I say, Hey, I got 5,000 bucks.
Mike:Give me, each of those four companies, I need $5,000 worth, across four
Mike:companies, that person does all that delivers them back to me.
Mike:So I , took the 5,000 in cash.
Mike:I got the stock, but I issued Matt, ETF shares.
Matt:Okay.
Mike:All Right.
Mike:So there's three participants here, Matt.
Mike:You're the owner of the shares.
Mike:I'm the ETF guy and I've got my authorized, participant AP.
Mike:Now, why is this important?
Mike:Because way that the investments work is that as buyers and sellers come into
Mike:that market, I'm using the AP for doing a lot of the I don't have to pass on
Mike:capital gains within my fund to Matt.
Mike:So I have gains, burger king does really well.
Mike:And so someone decides to sell the ETF goes up.
Mike:My ETF goes up because burger king has up.
Mike:That's great.
Mike:So someone Matt decides to sell, I can give back his money we exchange
Mike:in kind it's called the AP exchanges.
Mike:And I don't have to pass on capital gains to anybody.
Mike:Whereas the mutual fund cannot do that.
Mike:I have to sell burger king on the mutual fund now, and I'm giving Matt back
Mike:$5,000 he bought the mutual fund version.
Mike:I have to sell the burger king at a capital gain because it's gone
Mike:up and I have to pass that on to existing shareholders that gain
Matt:I
Mike:that in a nutshell is how it works now for the listeners.
Mike:Let me summarize.
Mike:Okay.
Mike:If you buy the ETF.
Mike:You do not get hit with the capital gains until you sell your own ETF.
Mike:Okay.
Mike:But as you're holding that, you're really not going to get hit with a
Mike:capital gains, if you own a mutual
Matt:it's all happening within the family.
Mike:It's all within the family.
Matt:is it's so it would be like, literally, if did a whole bunch stuff
Matt:inside our house, It doesn't matter.
Matt:It's if you your family swapped outfits, right?
Matt:And we, to changing, I've upon this scarf, I'm going to take
Matt:off this hat, bullet, blah.
Matt:No one sees that until you leave the house.
Matt:And it has no effect on the outside world until that happens.
Matt:Whereas with a mutual fund you sort of like get a window into that.
Matt:What it every day?
Mike:Yeah.
Mike:It's the mechanics, not every day?
Mike:is throughout year, but it's the mechanics of how it works is different.
Mike:We talked a a little bit about, but the upshot to investors is you can get
Mike:hit with capital gains distributions.
Mike:Even if you do not buy or sell your mutual because of the way it works inside the
Matt:All right.
Matt:Let me ask you kind of I'm going to try and channel the listeners.
Matt:So if it's from them, it's an intelligent question, but I, I was about to say
Matt:this may seem like dumb question.
Matt:No, no questions from the listeners are intelligent questions, given that,
Matt:given this advantage in terms of.
Matt:Capital gains taxes because all that churn is happening inside the house.
Matt:in the family.
Matt:Is there any reason why you would prefer the fund version
Matt:of something versus the ETF?
Mike:In my opinion, in my practice, I recommend ETFs 99% of the time.
Matt:That's interesting.
Matt:Wow.
Mike:there's, but there is a reason there is a pro for the mutual funds.
Mike:One of the things I like about them you can do automatic investments
Mike:and withdrawals from mutual.
Mike:They're often set up that way.
Mike:So let me give you an example.
Mike:I have an Iram and an individual retirement account.
Mike:That's invested in the S and 500, and I'd like to throw $500 a month into that.
Mike:Cause I know I can do 6,000 throughout the year.
Mike:So every month from my paycheck, I throw 500 in there.
Mike:You can set, at Vanguard or other places you could set a month withdrawal and add
Mike:it to my IRA, which is invested in the S and 500 mutual fund and throw it in there.
Mike:And so that's automatic.
Mike:And the other thing is that you can automatically reinvest all the dividends
Mike:and interest dividends in mutual funds.
Mike:So you can select just reinvest all the interest and dividends in the mutual fund.
Mike:And it just stays in there.
Matt:And you can't do that with
Mike:That's built into mutual funds more often than ETFs.
Mike:So there may be technology and ways that you can set that up at
Mike:fidelity and say, oh yeah, do that.
Mike:I just described into an ETF and they might do that.
Mike:I haven't seen that personally, but the listeners let us know, oh yeah, this easy.
Mike:Somebody to screenshot or, send me an email on that.
Mike:If that's really easy with ETFs well, but I do know with mutual.
Mike:funds, That's always been a benefit that it's easy to
Mike:automatically invest and reinvest.
Matt:So let's say I'm sitting here and I'm thinking to my Ah darn it.
Matt:I wish we'd had this episode a year ago because given the benefits ETFs and what
Matt:we now know is the giant tax bill that I, and other people may facing, coming up.
Matt:I'd like to not have mutual fund.
Matt:want that.
Matt:I want ETF version.
Matt:Can you do that?
Matt:Can you explain.
Mike:Yeah, I've heard from Vanguard that they will let you do that.
Mike:But I think is very particular to Vanguard.
Mike:And I'll, say that in all.
Mike:Talk to that in one sec, the general answer is no, , if I
Mike:own a mutual and I put in 50,000
Mike:five years ago and it's worth 80,000 today, I'd have to sell the mutual
Mike:fund and take $30,000 capital gains.
Matt:Ooh.
Mike:And then reinvest that into the ETF.
Mike:So you might not want to do
Mike:that,
Matt:worth it Not
Mike:So you might not want to do that, but at Vanguard, I know that they
Mike:have, I told you it's rappers, right?
Mike:ETF, wrapper, mutual fund wrappers around the assets.
Mike:They actually set it up.
Mike:it's the same underlying investment, the S and P five.
Mike:They have, a hundred million dollars, probably billions, but anyway, a
Mike:hundred million dollars in the S and 500, they sell that investment as an
Mike:ETF and they sell it as a mutual fund.
Mike:The exact same underlying thing.
Mike:That's the way they set it.
Mike:up internally inside the house.
Mike:So they've allowed investors.
Mike:If you want to whichever one, they can do that in kind inside the house.
Mike:And not have a taxable event.
Mike:So if you happen to have Vanguard account and Vanguard
Mike:funds, you can look into that.
Matt:That's interesting as well.
Matt:You know what this feels like to me is speaking of Vanguard.
Matt:You've already mentioned that mutual funds have this long history going back 1924.
Matt:And then what we saw was a disrupt.
Matt:That came in with low cost index fund opportunities retail investors.
Matt:Me and that the, and again, this is going to the other episode that may end
Matt:up following this on the radio or going ahead of it in podcast, but, we just did
Matt:it an episode on this, on, on fees and.
Matt:You know There was this disruption because all of a sudden you had
Matt:this advantage of paying lower fees, which could really pay off.
Matt:As we went over 20 years, it feels like given this capital gain.
Matt:Advantage that there is a disruption to mutual funds in the form of ETFs.
Matt:That may be the whole market, the whole retail market hasn't caught up to as
Matt:an availed themselves of, is that case?
Matt:Do see over time, more and more people over to ETFs, given this tax advantage?
Mike:Yeah, that's a good I don't have any data on, do I see more switching over?
Mike:ETF flows are going to be in terms of the data and money going in And out.
Mike:ETF flows will continue to rise because they are newer.
Mike:They're only 20, 25 years old.
Matt:And they're getting more popular.
Mike:there, and course they're becoming more popular and We just
Mike:mentioned there are new products being launched under this wrapper.
Mike:So I expect that ETF ownership, the number of dollars in ETFs continue
Mike:to grow, but the number of dollars in mutual funds going through too.
Mike:I have a good sense of the data, which way we're going, but I would agree that
Mike:there's a lot of reasons for owning ETF, more, they're a newer version of
Mike:the same thing some newer advantages.
Matt:We really should wrap this up in second, but I know you're going to
Matt:be out some more material for people who are interested in this and really
Matt:want to understand the landscape.
Matt:So where can people find more info on
Mike:Yeah.
Mike:We're going to have a whole article on this?
Mike:because it was more of a masterclass deep dive into the differences.
Mike:mortonfinancial.com there's articles.
Mike:There'll be an article posted within a few weeks up there.
Mike:And particularly we'll also dive into an example of what I was talking
Mike:about with the capital gains, why you might get hit with capital gains.
Mike:Holding a mutual fund and taxable in your brokerage account.
Mike:I'll an example there with some dollars and numbers on how that works.
Matt:All right.
Matt:So just to sum all of this up, this has been a conversation about
Matt:mutual funds, ETFs index funds, and the various crossovers among them.
Matt:And the bottom line is where started, which is there are
Matt:there they're largely similar.
Matt:And there are overlaps, but you have to understand the differences
Matt:because they can have tax they can have fee consequences, and
Matt:this is just worth understanding.
Matt:And so I encourage people, listen to this the podcast feed so that you can
Matt:hit that rewind button and then check out that website for more information,
Matt:Mike, thanks running through all of this.
Mike:Yeah, my pleasure.
Mike:Thanks for joining us on financial planning for entrepreneurs.
Mike:If you like, what you heard, please subscribe to and rate the podcast on
Mike:Apple iTunes, Google play Spotify, or wherever you get your podcasts.
Mike:You can connect with me on linkedin or mortonfinancialadvice.com.
Mike:I'd love to get your feedback.
Mike:If you have a comment or question, please email me at
Mike:.
