ETFs and index managed funds are both useful tools for creating portfolios. But there are important differences between them. We list out what they are.

When it comes to constructing a portfolio, deciding which tools to use can be tricky.

Index managed funds and ETFs both offer investors an easy way to purchase a unit-based share in a portfolio tracking a specific investment index. In many cases, both structures own the same underlying assets.

The decision on which vehicle to use often comes down to the structure best suited to your particular circumstances.

Here are some similarities and differences worth knowing when deciding whether to use ETFs or managed funds in your portfolio:

 

Similarities between ETFs and managed funds

1.     Asset ownership

2.     Diversification

3.     Regulation

4.     Structure

5.     Purpose

Differences between ETFs and managed funds

1.     Adding new funds

2.     Pricing

3.     Transparency

4.     Trading flexibility

5.     Access

Asset ownership

The legal structure of both ETFs and managed funds is a trust. The underlying assets are owned by the trustee on behalf of the unit holders.

Each financial year, unit holders receive all the dividends (less expenses) and any realised capital gains (less realised capital losses) from the underlying investments. Investors pay tax on these distributions (usually quarterly or half-yearly) at their marginal tax rate.

Adding new funds

Managed funds allow investors to cost-effectively add or remove money through regular contributions or deductions, making them suitable for dollar-cost-averaging.

With ETFs, investors are free to buy additional units at any time during the trading day, but brokerage is payable on every transaction. Brokerage is typically a fixed dollar amount, so ETFs may suit investors making large or irregular investments.

Diversification

By pooling money from many investors, both fund types provide small investors with better portfolio diversification than on their own.

Both ETFs and managed funds can provide broad exposure to different asset classes, industries, market segments and even countries.

Pricing

Orders to buy or sell ETF units are executed throughout the trading day at the current market price, so pricing changes continuously.

Orders to purchase or redeem units in a traditional managed fund are executed at the end-of-day price, or net asset value (NAV).

Regulation

ETFs and managed funds are subject to all the usual requirements for registered schemes under the Corporations Act.

As trusts, the underlying assets are not owned by the product issuer and are usually held by a third-party custodian, making them unavailable to creditors in the event of default.

Transparency

Compared with many active managed funds, ETFs are extremely transparent (traditional index managed funds are also transparent).

Information about an ETF's underlying holdings is readily available on the investment manager's website. Managed funds are not required to disclose their portfolio holdings and often only list their top 10 investments.

Structure

Managed funds and ETFs generally have an open-ended structure, which means the number of units on issue is not fixed. Both structures regularly create and redeem units depending on supply and demand, so liquidity is usually available.

Trading flexibility

ETFs provide a familiar environment for investors comfortable with trading on the ASX and those wanting to use sophisticated trading strategies like limit and stop-loss orders. They can also be used with margin lending strategies.

Managed funds do not offer similar trading opportunities

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