ETF Vs. Mutual Fund Returns

by Geri Terzo

Investors who prefer to direct capital to money managers may choose between different types of portfolios, including exchange traded funds (ETFs) and actively managed mutual funds. ETFs can be a type of mutual fund but there are still key differences. ETF investors pay minimum fees for average returns. The managers of actively managed mutual funds are expected to generate above average profits.

Fees

The returns, or profits, that investment funds are expected to generate are largely tied to the expense ratios, or fees, that investors pay. An ETF is a passively managed investment portfolio because the fund manager merely attempts to do as well as some other industry gauge. Subsequently, fees in these funds tend to be lower versus actively managed mutual funds. A mutual fund manager tends to earn higher fees because he is supposed to buy and sell financial securities so that -- even if a mutual fund is pegged against some benchmark -- returns exceed those in the broader markets.

Trends

Although mutual fund returns are generally expected to exceed those generated by ETFs, they sometimes fall behind. If lackluster mutual fund returns persist, the argument for more expensive active management over ETFs becomes less compelling. The lion's share of managed assets are allocated to mutual funds compared with passive portfolios including ETFs. Investors sacrifice billions of dollars in profits due to poorly managed mutual funds, according to a 2011 article on the CBS Money Watch website. For the 10-year period beginning in 2001, however, the trend towards passive management gained momentum while mutual funds lost some market share.

Strategy

Regional tax laws impact the returns that investors earn in the financial markets. As a result, tax obligations owed on investments diminish the overall profits. There are tactics that can lessen this burden. Mutual funds generally make annual distributions in the form of cash or additional portfolio units each year. In the US, those distributions become taxable. Investment manager Frank Armstrong of Investor Solutions is cited on the Reuters website as selling units in a faltering mutual fund prior to any yearly distributions. He replaces those portfolios with similarly comprised ETFs to bypass the tax obligation on any payout.

Consideration

It is not uncommon for an asset management firm to offer investors both ETF and mutual fund portfolios to choose from. Both portfolios might be dedicated to a similar asset class, but the cost structure and profit expectations often differ. For instance, in 2011 fixed income firm Pacific Investment Management Company (PIMCO) planned to launch a bond ETF designed similarly to one of its actively managed mutual funds. Although the firm's mutual fund manager has greater flexibility to achieve the desired returns, the profits in the ETF were expected to rival that of the actively managed fund, according to the Financial Advisor website.

About the Author

Geri Terzo is a business writer with more than 15 years of experience on Wall Street. Throughout her career, she has contributed to the two major cable business networks in segment production and chief-booking capacities and has reported for several major trade publications including "IDD Magazine," "Infrastructure Investor" and MandateWire of the "Financial Times." She works as a journalist who has contributed to The Motley Fool and InvestorPlace. Terzo is a graduate of Campbell University, where she earned a Bachelor of Arts in mass communication.

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