A simple and easy-to-understand explanation of the differences, relationship, and management methods of ETFs and mutual funds
When you start investing, you will almost certainly encounter the two terms “mutual fund” and “ETF.” Both are products that allow for diversified investment with small amounts of money, and they can be purchased if you have a brokerage account. Because the names are similar, many people are confused about which one to choose or what the differences are.
In conclusion, an ETF is a type of mutual fund. ETF stands for “Exchange Traded Fund,” and it refers to a mutual fund that is listed on a stock exchange. In other words, in a broad sense, an ETF is a type of mutual fund, and the two have a relationship like parent and child or siblings. However, there are clear differences in how they are bought, how their prices are determined, the costs involved, and how they are best used.
In this article, I will first explain the mechanisms of mutual funds and ETFs, and then clarify the relationship between the two. After that, I will look at the differences one by one, and finally, I will describe specific ways to manage them and points to keep in mind. I have avoided technical jargon as much as possible so that even beginners can understand.
What kind of product is a mutual fund?
A mutual fund is a product where money is collected little by little from many investors into one large fund, which is then invested by investment professionals in stocks, bonds, real estate, etc., and the results are shared according to the investment amount. It is often compared to a “variety pack.” It is difficult to buy stocks of hundreds of companies one by one yourself, but if you buy one mutual fund, you can get an effect close to investing in the entire contents collectively.
Three types of companies are involved in this mechanism. First, there is the investment trust management company (asset management company) that issues investment instructions. They decide which stocks to include and how much. Next is the trustee company, such as a trust bank, which actually holds and manages the assets. And finally, there are sales companies such as securities firms and banks that sell the products to investors and act as windows for purchases and cancellations. The money deposited by investors is managed at a trust bank, separate from the assets of the management company or the sales company. Because of this segregated management, even if a sales company goes bankrupt, the assets of the mutual fund itself are protected.
The price of a mutual fund is called the “net asset value” (NAV). This is calculated by dividing the total net assets, which is the total assets held by the fund minus liabilities, by the number of units issued. In principle, it is calculated once a day after the market closes. For ordinary mutual funds, you do not know the price at the time you place an order. The price is determined later, in the form of “purchasing at the net asset value calculated based on the closing price of the day.”
What kind of product is an ETF?
ETF stands for “Exchange Traded Fund.” Among mutual funds, it refers to those that are listed on a stock exchange and can be bought and sold just like stocks.
While ordinary mutual funds have their prices determined “after you place an order,” ETFs have prices that move in real-time during trading hours, just like stocks, and you can buy and sell them while watching those prices. You can also use the same order methods as stocks, such as market orders and limit orders. If an ETF is listed on the Tokyo Stock Exchange, the trading hours are the same as for stocks, which is during the day on weekdays.
Most ETFs are managed to track a specific index. For example, the Nikkei Stock Average, TOPIX, the S&P 500 (a representative US stock index), or an index covering stocks from all over the world. Therefore, buying an ETF means investing in a large number of stocks included in that index collectively. By buying just one ETF, you can diversify your investment into major Japanese companies or large US companies.
Recently, many ETFs have been listed that track not only stocks but also bonds, real estate investment trusts (REITs), commodities such as gold and crude oil, and even specific themes (semiconductors, robots, environment, etc.). The choices are expanding year by year.
The relationship between mutual funds and ETFs: ETFs are “listed mutual funds”
Here, I will clarify the relationship between the two again. ETFs are also within the framework of mutual funds under the law. In other words, ETFs are included in the broad category of “mutual funds.” Generally, when people say “mutual fund,” they often refer to “ordinary mutual funds” (unlisted mutual funds) that are not listed, and they are discussed separately from ETFs.
For example, a mutual fund is like “fruit,” and an ETF is like a “mandarin orange.” A mandarin orange is a type of fruit, but when you say “fruit,” it also includes apples and grapes. Similarly, the category of mutual funds includes not only ETFs but also unlisted mutual funds. And currently, the latter is far more numerous in terms of both the number of funds and the number of individual users.
Also, as a product that is listed like an ETF, there is also a REIT (Real Estate Investment Trust). This is a product that invests in real estate, and although it is a different category from an ETF, it is similar in that it can be bought and sold on an exchange. It is easier to organize your thoughts if you also know the differences from such products.
Differences in trading methods and price determination
The biggest difference between mutual funds and ETFs is the method of trading and how the price is determined.
Unlisted investment trusts are bought and sold by placing orders with securities companies or similar institutions at the net asset value (NAV) calculated once a day. At the time of placing an order, you do not know the exact price at which you will be able to buy; for example, if you place an order in the evening, it may be executed at the NAV of the next business day. Additionally, for investment trusts that invest in overseas assets, it can take several days from the order to execution and final settlement. In return, it is common to be able to buy by specifying a specific amount, starting from very small amounts like 100 yen or 1,000 yen. You can also easily set up automatic monthly investments, such as “10,000 yen per month.”
On the other hand, ETFs can be bought and sold at any time during trading hours at the price displayed on the market, just like stocks. You can also place limit orders, such as “buy when it reaches this price,” while watching price movements. However, you can only buy in integer multiples of the minimum unit set by the exchange, such as per share or per 10 shares, and you cannot buy by specifying a specific monetary amount. The price of an ETF varies greatly depending on the product; some can be bought for a few hundred yen, while others require tens of thousands of yen. This aspect can be difficult for those who want to invest small amounts regularly. However, recently, some securities companies have begun offering services that allow for small-amount ETF accumulation or mechanisms to buy in units of less than one share.
In short, there is a tendency that if you want to control “when and at what price” in detail yourself, an ETF is suitable, and if you want to “invest automatically every month without thinking too much,” an unlisted investment trust is suitable.
Discrepancy between net asset value and market price
A feature of ETFs that investment trusts do not have is that there are two prices: “net asset value” and “market price.” For ETFs, the net asset value is also calculated by dividing the total net assets by the number of units, but actual trading is concluded at the price set by buyers and sellers in the market. Therefore, a slight discrepancy can occur between the net asset value and the market price.
However, mechanisms are in place to ensure this discrepancy does not become too large. There are large securities companies called “authorized participants” for ETFs, and if the market price of an ETF becomes too high or too low compared to the net asset value, they trade to take advantage of that difference. For example, if the market price becomes overvalued, they create new ETFs and sell them on the market; if it becomes undervalued, they buy ETFs on the market and exchange them for the underlying stocks. Through this trading, the price discrepancy naturally shrinks. However, when the market moves significantly or for ETFs with low trading volume, the discrepancy may widen.
Differences in management costs
Management expenses are also an important point of comparison. While you hold an investment trust, a fee called a “trust fee” is deducted daily from the trust assets. This corresponds to the remuneration for the management company, the sales company, and the trustee company. Some products charge a sales commission at the time of purchase, but recently, “no-load” products that do not charge a sales commission have become mainstream. There are also products that charge a fee called a trust asset retention fee when you cancel.
For ETFs, fees corresponding to trust fees are also charged in the same way. In general, the trust fees for index-type ETFs are often kept very low, and they may be at the same level or slightly lower than unlisted index investment trusts that track the same index. However, ETFs incur trading commissions paid to the securities company each time you buy or sell. The level of commissions varies depending on the securities company and the transaction amount, and recently some securities companies offer plans with zero commissions. Furthermore, ETFs have a less visible cost called the “spread,” which is the difference between the selling price and the buying price. If the ETF is actively traded, the spread is small, but for ETFs with low trading volume, you may end up buying or selling at a price that is less favorable than you expected.
Therefore, it cannot be said unconditionally which is cheaper. The total cost changes depending on whether you invest steadily every month, buy only a few times with a lump sum, or which product you choose. The important thing is to be aware of the overall cost, including trading commissions and spreads, rather than judging only by the trust fee.
Differences in dividends and reinvestment
There are also differences in how dividends are handled. Investment trusts and ETFs may pay dividends or interest earned from management to investors as distributions. Many unlisted investment trusts offer a “dividend reinvestment course” that automatically reinvests dividends, allowing you to buy more of the same product with the received dividends without any hassle. This mechanism is convenient for those who want to increase their assets steadily over the long term by taking advantage of the compounding effect.
In the case of ETFs, dividends are basically deposited into your account in cash. If you want to reinvest this, you need to place an order yourself to buy more. While it takes effort to reinvest, it has the advantage of allowing you to decide how to use the money at your own discretion. For those who want to use annual dividends to supplement their living expenses, it can be said to be an easy-to-receive form.
Note that when a dividend is paid, the net asset value drops by that amount. A dividend is not something you “gained” as a profit, but simply a form of receiving the results of management as cash. It is better to avoid judging the quality of a product solely by the size of the dividend.
Differences in management methods: Index type and active type
As for the philosophy of management, there are two styles for investment trusts and ETFs: “index type” and “active type.”
The index type is managed with the goal of achieving the same price movement as a specific index, such as the Nikkei Stock Average or the US S&P 500. Since the stocks included in the index are incorporated mechanically, there is less management effort, and consequently, the trust fee is lower. The majority of ETFs are of this index type.
The active type is managed by investment professionals who select stocks based on their own research and analysis, aiming to outperform the index. If successful, you can expect returns above the market average, but because research costs money, trust fees tend to be higher compared to the index type. Also, it is not guaranteed that they will always outperform the index, and it is said that many active types do not beat the index in the long term. There are many active-type unlisted investment trusts, but in recent years, active-type ETFs have also been gradually increasing.
For beginners, it is considered a standard approach to start with a low-cost index type. This is because it is easy to understand, low in cost, and easy to hold for a long time.
Taxes and treatment under the new NISA
In terms of taxes, there is no major difference between investment trusts and ETFs. In principle, both are subject to a tax of approximately 20% on profits earned from sales (capital gains) and on dividends received. However, if you manage them in a NISA (Small Investment Tax Exemption System) account, these profits will be tax-free within a certain range.
The new NISA that began in 2024 includes a “tsumitate investment quota” and a “growth investment quota.” You can invest up to 1.2 million yen per year in the tsumitate investment quota and up to 2.4 million yen per year in the growth investment quota, with a total lifetime tax-free holding limit of 18 million yen (of which up to 12 million yen can be in the growth investment quota).
This is where the difference between ETFs and investment trusts comes in. Products that can be purchased in the tsumitate investment quota are limited to investment trusts that meet certain criteria suitable for long-term accumulation, and a very small number of ETFs. On the other hand, the growth investment quota allows for a wider selection of products, so many ETFs are also eligible. However, depending on the product, some may not be eligible, and the details of the system may change in the future. Before purchasing, please check the latest eligible products through your securities company’s information or official guidance from the Financial Services Agency.
Specific ways to proceed with management
So, how should you actually go about managing your investments? Here is a simple explanation of the basic flow.
First, open an account with a securities company. It is also advantageous to open a NISA account at the same time, as the profits earned from your investments will not be taxed.
Next, consider your goals and time frame. The products you choose will depend on whether the funds are for long-term management, such as retirement funds, or funds you plan to use in a few years. If you are considering long-term accumulation, a common method is to invest a fixed amount every month in low-cost index-type investment trusts that track global or US stocks. This is a technique called “dollar-cost averaging,” which automatically buys fewer shares when prices are high and more when they are low, so you don’t have to worry about the timing of your purchases.
ETFs are suitable for those who want to buy and sell while watching price movements themselves, those who want to invest a lump sum at a specific time, or those who want to receive dividends in cash. The high liquidity, which allows you to buy and sell at any time during trading hours, is a major advantage.
Furthermore, once you have chosen your products, consider “rebalancing” your asset allocation every few years. For example, suppose you decided to hold stocks and bonds in a 7:3 ratio, but due to a rise in stock prices, it has become 8:2. In this case, you would sell some of your stocks and buy more bonds to return to the original ratio. By doing this, you can prevent your risk from becoming higher than you initially anticipated.
Finally, do not be swayed by short-term price movements. The market goes up and down repeatedly. If you panic and sell when prices drop significantly, you will lock in your losses. It is important for continuing your investment to decide in advance that “these funds are for long-term holding.”
Points to be careful about
There are several points to be aware of that are common to both ETFs and investment trusts.
Neither is a product with a guaranteed principal. The value may drop and fall below the amount you invested. When investing in overseas assets, gains and losses will fluctuate further due to exchange rate changes.
With ETFs, products with low trading volume may become difficult to buy or sell at your desired price. When choosing, check the total net assets and the activity of trading. Also, leveraged or inverse ETFs, which are designed to move at twice the rate of the Nikkei Stock Average or in the opposite direction, are products created for short-term trading, and holding them for a long time can lead to unexpected asset depletion. Please judge whether to use them after fully understanding how they work.
With investment trusts, the trust fees that are deducted daily can make a big difference over a long period. Even for products that track the same index, if the costs are different, there will be a difference in the future value of your assets. It is important to check the costs before purchasing.
Also, for both types of products, if management does not go well or if the scale becomes too small, “early redemption” may occur, ending the management midway. When redeemed, your money will be returned at the price at that time, but since it will be sold at an unexpected time, it is safer to check the scale and management status of the product from time to time just in case.
Summary: Use them according to your needs
ETFs are listed investment trusts and are part of the broader category of investment trusts. Unlisted investment trusts are easy to accumulate automatically from small amounts, and dividends can be reinvested without hassle, making them suitable for long-term, steady investing. ETFs can be bought and sold at real-time prices during trading hours, and many have lower management costs, making them suitable for people who want to buy and sell while watching prices or who want to manage their investments flexibly.
It is not a matter of which is superior, but rather choosing according to your purpose and how you intend to use them, and in some cases, it is good to use them together. For example, you could use unlisted index investment trusts for accumulation and ETFs for investing lump sums.
The important thing is to understand the mechanisms and costs, and to continue for a long time with an amount that you can afford.