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/

All right.

So our podcast listeners, we're continuing this discussion, our radio listeners.

We hope we got you back onto the podcast.

Let me just ask about a couple of terms that we've thrown around and

that people throw around in general.

They about sometimes they, talk they definitely do about mutual funds.

Most people have heard of mutual Some people have heard of ETFs

and now they definitely have, and we talk a lot about index funds.

W what are, let's just talk about the index.

Fund part of this, how are they the same or different than ETFs and mutual

Yeah, that's a great question.

I get this the time.

ETFs are index funds,

or wait, are they mutual funds?

Or people just use the word funds, now you have a good understanding,

a good start to mutual.

Versus ETFs.

Okay.

What are index funds?

What are index.

funds?

Index funds are a fund that tracks index.

Alright.

And an index.

You can define it any way you want.

right, Matt, I could have fast food chain index.

I'm going to hold equal weight of McDonald's burger king

Chick-fil-A and taco bell.

And that's mine.

And now I, now someone that's my index and it's easily defined.

All right.

That's that is a prerequisite for an index.

You have to able to define it algorithmically, easily defined,

and then you could create a fund that tracks that index.

Mine is very simple.

It's for companies equal weight, 25% of each in a fund.

So Matt, you can go ahead and launch.

Called the the Matt fast chain fond based on the Morton fast food index.

And it.

just holds those four things.

Super easy peasy.

So an index is just a, it's a sample from a particular sector

or it's a sample of anything.

in, yeah.

Think of it this way.

It's really just a well-defined set.

Within the investible So S and P 500 500 companies in the U S total us

stock market, 30, 33,000 companies here in the U S we could do the

Australia total Australian market.

Okay.

So those are all examples of an index that are easily defined.

you know what they are?

And then you could have a fund that tracks that index.

Now it can literally be invested in what the index or it can track it.

Very closely by holding 80% of it will get very close tracking say, and there's

all kinds of mathematics behind all that.

Okay.

Index fund is just simply a fund that tracks an index are well-known ones,

total us stock market, total international markets, , the and P 500, right?

Those kinds of things.

Those are all indexes.

Now index fund is a fund that tracks index.

It could be an ETF exchange traded.

Where it could be a mutual fund.

So it could be either one

And.

An index fund it.

One of the of it is that if it's an index, it's just going to track

whatever you've put in that index.

I whole S and P it could the whole stock market.

It could know entertainment companies.

It could construction, whatever it is.

So since it set up.

You don't have do a lot that point.

You it's, not like a mutual fund where it's like, all right, what do

we think is a good investment today?

All right Hold a a sec, because see you just work you're thinking like

most people out there, I love a mat.

It's not like a mutual fund.

That's going to be actively managed, but remember an ETF is a fund.

It could be actively managed as well.

So it doesn't have to be mutual.

So let's talk about active versus passive.

We just define index fund and you're exactly right.

Index funds are very passive once I've defined what it is.

There's not a lot of work to it.

You have to create a fund that tracks it, not super hard using computers these

days, and you're up and running and you can work with a small team to do that.

So we call that very passive, passively managed.

It's just managed to whatever that index.

Okay.

Active is where we're making bets.

Hey, I think the energy sector is going to be better than the discretionary

consumer sector the next six months.

So I'm going to overweight my allocation to that sector.

And then we'll reevaluate in six months.

So now I've got a of researchers.

I'm a star manager.

And it more to do that I'm making active bets so that the fund

usually has a expense to it.

there's more involved and we're making active bets on what I predict

future to be, to get outsized returns is the whole point again though.

All right.

So there's my team.

I could launch that as a mutual fund.

That's been typically in the past because they a longer history,

but I can also launch as an ETL.

I can have actively managed ETF and going to see more and more of these.

So just be aware that you to know what you're investing in, whether it's a

mutual fund or an ETF, just understand it's the S and P or the total us

or the energy sector, or it's star manager or this particular slant to it.

That's more actively.

manage.

So you could have a mutual fund.

You could have an ETF, you could have a mutual fund that's actively managed.

You can have a mutual fund.

That is an index that is relatively passive.

You could have an ETF that is relatively passive or.

Relatively active.

So you have all these flavors and we've talked a lot about, there are

some , minor differences terms of when settled and whether they're

there they're traded within the day.

And whether, they have the same value as the underlying assets,

but what does it mean investors?

What's the difference to me?

Like why do I care about these diff

Yeah.

And I will mention one other thing I'm gonna answer your question.

I love the way you put that, could have this thing or that thing, it could be

this way or this way, get ready because ETFs are now holding futures contracts.

They're holding options inside the ETF wrapper.

So who your $1,000 you can buy the upside of the total us stock market,

but be protected on the downside.

a put option inside the ETF wrapper.

Okay.

So get ready for these only triple levered, but also what we call.

buffered, Where you're PR you're getting up to 10% of the upside, but

protected on the downside in these ways.

So it's getting very complicated, what people are launching

inside the wrapper of an ETF.

Throwing that out there for the listeners to get

All right.

Look, if going to throw something out, I I don't know, throw something Let me tell

you, we're going to do a show about this.

We're going to do a show about this because my sense is things

get more and more complicated?

It advantages people who are on the inside have a lot of

Advantage wall street

And it's not as that more complex and you have to understand

all the legalees and Latin, it's not necessarily advantages to you,

but anyway, let's talk about what matters to you and me and people like

us in terms of these differences.

so I'm just going to highlight one thing and then get into that.

The, remember the difference, one of the differences between ETFs and mutual.

Mutual funds settle at the end of day.

And I told you, they settle on their nav.

All Right.

Which is , , the net asset value, the prices of all the underlying stuff.

So in mine, I had those for, a fast food chain.

So at the end of the day, they stopped trading on the open

market I can look up the exact price, the last trade of each one.

And that is what my mutual.

fund Value is so it set at the end of the day.

And then Matt, you invested 5,000 bucks and you get exactly $5,000

worth of those four things underneath.

Okay.

Net asset value.

Whereas if buy them in the stock, market's going up and down up

and down and if you a a market price, you're just buying that ETF.

The ETF version of my.

four fast food chains is going up and down throughout the day.

And if you invest 5,000, you go get that spot price at that time.

different ways they work now, why is this important for investors?

We started the show with that capital gains problem.

All Right.

That you could get hit with capital gains, even though all you did

was just invest into a mutual.

The

reason why let me talk a little bit about how I told you how the mutual funds work.

The nav ETFs.

On the other hand, Matt in 5,000 bucks, my ETF has to issue

$5,000 of shares over to Matt.

The way I do that is on the ETF guy and I give him the ETF shares, but I've

got to buy the other four underlying.

Stocks I have a partner who does that?

He's called the authorized participant.

Okay.

So he's my friend, he's partner.

And I say, Hey, I got 5,000 bucks.

Give me, each of those four companies, I need $5,000 worth, across four

companies, that person does all that delivers them back to me.

So I , took the 5,000 in cash.

I got the stock, but I issued Matt, ETF shares.

Okay.

All Right.

So there's three participants here, Matt.

You're the owner of the shares.

I'm the ETF guy and I've got my authorized, participant AP.

Now, why is this important?

Because way that the investments work is that as buyers and sellers come into

that market, I'm using the AP for doing a lot of the I don't have to pass on

capital gains within my fund to Matt.

So I have gains, burger king does really well.

And so someone decides to sell the ETF goes up.

My ETF goes up because burger king has up.

That's great.

So someone Matt decides to sell, I can give back his money we exchange

in kind it's called the AP exchanges.

And I don't have to pass on capital gains to anybody.

Whereas the mutual fund cannot do that.

I have to sell burger king on the mutual fund now, and I'm giving Matt back

$5,000 he bought the mutual fund version.

I have to sell the burger king at a capital gain because it's gone

up and I have to pass that on to existing shareholders that gain

I

that in a nutshell is how it works now for the listeners.

Let me summarize.

Okay.

If you buy the ETF.

You do not get hit with the capital gains until you sell your own ETF.

Okay.

But as you're holding that, you're really not going to get hit with a

capital gains, if you own a mutual

it's all happening within the family.

It's all within the family.

is it's so it would be like, literally, if did a whole bunch stuff

inside our house, It doesn't matter.

It's if you your family swapped outfits, right?

And we, to changing, I've upon this scarf, I'm going to take

off this hat, bullet, blah.

No one sees that until you leave the house.

And it has no effect on the outside world until that happens.

Whereas with a mutual fund you sort of like get a window into that.

What it every day?

Yeah.

It's the mechanics, not every day?

is throughout year, but it's the mechanics of how it works is different.

We talked a a little bit about, but the upshot to investors is you can get

hit with capital gains distributions.

Even if you do not buy or sell your mutual because of the way it works inside the

All right.

Let me ask you kind of I'm going to try and channel the listeners.

So if it's from them, it's an intelligent question, but I, I was about to say

this may seem like dumb question.

No, no questions from the listeners are intelligent questions, given that,

given this advantage in terms of.

Capital gains taxes because all that churn is happening inside the house.

in the family.

Is there any reason why you would prefer the fund version

of something versus the ETF?

In my opinion, in my practice, I recommend ETFs 99% of the time.

That's interesting.

Wow.

there's, but there is a reason there is a pro for the mutual funds.

One of the things I like about them you can do automatic investments

and withdrawals from mutual.

They're often set up that way.

So let me give you an example.

I have an Iram and an individual retirement account.

That's invested in the S and 500, and I'd like to throw $500 a month into that.

Cause I know I can do 6,000 throughout the year.

So every month from my paycheck, I throw 500 in there.

You can set, at Vanguard or other places you could set a month withdrawal and add

it to my IRA, which is invested in the S and 500 mutual fund and throw it in there.

And so that's automatic.

And the other thing is that you can automatically reinvest all the dividends

and interest dividends in mutual funds.

So you can select just reinvest all the interest and dividends in the mutual fund.

And it just stays in there.

And you can't do that with

That's built into mutual funds more often than ETFs.

So there may be technology and ways that you can set that up at

fidelity and say, oh yeah, do that.

I just described into an ETF and they might do that.

I haven't seen that personally, but the listeners let us know, oh yeah, this easy.

Somebody to screenshot or, send me an email on that.

If that's really easy with ETFs well, but I do know with mutual.

funds, That's always been a benefit that it's easy to

automatically invest and reinvest.

So let's say I'm sitting here and I'm thinking to my Ah darn it.

I wish we'd had this episode a year ago because given the benefits ETFs and what

we now know is the giant tax bill that I, and other people may facing, coming up.

I'd like to not have mutual fund.

want that.

I want ETF version.

Can you do that?

Can you explain.

Yeah, I've heard from Vanguard that they will let you do that.

But I think is very particular to Vanguard.

And I'll, say that in all.

Talk to that in one sec, the general answer is no, , if I

own a mutual and I put in 50,000

five years ago and it's worth 80,000 today, I'd have to sell the mutual

fund and take $30,000 capital gains.

Ooh.

And then reinvest that into the ETF.

So you might not want to do

that,

worth it Not

So you might not want to do that, but at Vanguard, I know that they

have, I told you it's rappers, right?

ETF, wrapper, mutual fund wrappers around the assets.

They actually set it up.

it's the same underlying investment, the S and P five.

They have, a hundred million dollars, probably billions, but anyway, a

hundred million dollars in the S and 500, they sell that investment as an

ETF and they sell it as a mutual fund.

The exact same underlying thing.

That's the way they set it.

up internally inside the house.

So they've allowed investors.

If you want to whichever one, they can do that in kind inside the house.

And not have a taxable event.

So if you happen to have Vanguard account and Vanguard

funds, you can look into that.

That's interesting as well.

You know what this feels like to me is speaking of Vanguard.

You've already mentioned that mutual funds have this long history going back 1924.

And then what we saw was a disrupt.

That came in with low cost index fund opportunities retail investors.

Me and that the, and again, this is going to the other episode that may end

up following this on the radio or going ahead of it in podcast, but, we just did

it an episode on this, on, on fees and.

You know There was this disruption because all of a sudden you had

this advantage of paying lower fees, which could really pay off.

As we went over 20 years, it feels like given this capital gain.

Advantage that there is a disruption to mutual funds in the form of ETFs.

That may be the whole market, the whole retail market hasn't caught up to as

an availed themselves of, is that case?

Do see over time, more and more people over to ETFs, given this tax advantage?

Yeah, that's a good I don't have any data on, do I see more switching over?

ETF flows are going to be in terms of the data and money going in And out.

ETF flows will continue to rise because they are newer.

They're only 20, 25 years old.

And they're getting more popular.

there, and course they're becoming more popular and We just

mentioned there are new products being launched under this wrapper.

So I expect that ETF ownership, the number of dollars in ETFs continue

to grow, but the number of dollars in mutual funds going through too.

I have a good sense of the data, which way we're going, but I would agree that

there's a lot of reasons for owning ETF, more, they're a newer version of

the same thing some newer advantages.

We really should wrap this up in second, but I know you're going to

be out some more material for people who are interested in this and really

want to understand the landscape.

So where can people find more info on

Yeah.

We're going to have a whole article on this?

because it was more of a masterclass deep dive into the differences.

mortonfinancial.com there's articles.

There'll be an article posted within a few weeks up there.

And particularly we'll also dive into an example of what I was talking

about with the capital gains, why you might get hit with capital gains.

Holding a mutual fund and taxable in your brokerage account.

I'll an example there with some dollars and numbers on how that works.

All right.

So just to sum all of this up, this has been a conversation about

mutual funds, ETFs index funds, and the various crossovers among them.

And the bottom line is where started, which is there are

there they're largely similar.

And there are overlaps, but you have to understand the differences

because they can have tax they can have fee consequences, and

this is just worth understanding.

And so I encourage people, listen to this the podcast feed so that you can

hit that rewind button and then check out that website for more information,

Mike, thanks running through all of this.

Yeah, my pleasure.

Thanks for joining us on financial planning for entrepreneurs.

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