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
Matt:

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:this long history going back: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:

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Mike:

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Mike:

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Mike:

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Mike:

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