ETFs versus mutual funds, and active versus passive

◈ 9 cards

Intraday at a market price versus once a day at NAV; creation and redemption keep the ETF near its NAV; “ETF” is not “index fund”; and why most active funds lag after fees — the fee gap in dollars.

Two wrappers for a portfolio

An exchange-traded fund (ETF) holds a portfolio, like a mutual fund, but its units are listed on an exchange — a TSX-listed index ETF trades all day at a market price, bought through a broker with a commission, exactly like a share. Compare a mutual fund, whose units are bought from and redeemed by the fund itself once a day at NAV, with no commission but, for an actively managed equity fund, a much higher MER.

	Index ETF	Active mutual fund
Where traded	on an exchange, through a broker	with the fund, through a dealer
When priced	continuously, at a market price	once a day, at NAV, after the order
Cost	commission per trade; MER ≈ 0.20 %	no commission; MER ≈ 2.0 %
Structure	open-end; units created and redeemed in large blocks	open-end; units issued and redeemed at NAV
Price vs NAV	market price ≈ NAV	price is NAV

Why the ETF's price stays near its NAV

A closed-end fund can drift to a 15 % discount because nothing pulls its price back. An ETF cannot, for long, because designated brokers can create new units by delivering the underlying basket to the fund, and redeem units by handing them back for the basket. If the ETF trades above NAV, a broker buys the basket, exchanges it for units, sells the units — and the premium closes. Below NAV, the reverse. That arbitrage channel is the mechanism; the exchange's rules are not.

"ETF" is not "index fund"

The two words describe different things. ETF is a wrapper — how the units trade. Index is a strategy — what the portfolio does. Most ETFs track an index at a low MER, which is why the words get confused; but there are actively managed ETFs, and there are index mutual funds. A question that treats them as synonyms is testing whether you know the difference.

The fee gap in dollars

$25,000 for 10 years, both portfolios earning 6 % gross. The index ETF at a 0.20 % MER:

=25000*(1+0.06-0.002)^10 = 43,933.59

The active fund at 2.0 %:

=25000*(1+0.06-0.02)^10 = 37,006.11

Difference: 6,927.48 — 28 % of the starting sum, on identical gross performance. Over 20 years the gap is 22,428.33. The active fund must beat the index by 1.8 points a year just to draw level.

Why most active funds lag

Here is the argument, and it does not depend on the EMH being true. Every share is held by someone. Add up every investor's holdings and you have the market; so the average dollar invested — active and passive together — earns the market return, before costs. Passive dollars earn the market return less a small fee. Therefore the average active dollar also earns the market return before costs — and active costs are higher. After fees, the average active fund must lag the index; the ones that beat it are balanced by the ones that trail it further, and the winners are hard to identify in advance. Add the EMH — prices already reflect what the manager knows — and the case for the low-cost index fund is complete. Module 14 tests it with twelve real shares against twelve.

Recompute

Over 20 years: ETF =25000*1.058^20 = 77,206.41; fund =25000*1.04^20 = 54,778.08; gap 22,428.33. Cold, the four contrasts: where traded, when priced, cost, price vs NAV.

Wrapper versus wrapper. The row that costs money is the third: a 1.8-point MER gap on 25,000 at 6 % gross is 6,927 after ten years and 22,428 after twenty.