Active ETFs vs Mutual Funds: What to Know Before Picking a New Fund 

Ivanna Hampton: Welcome to Investing Insights. I’m your host, Ivanna Hampton. Active fund choices are multiplying. Some big firms behind popular open-end funds are rolling out similar or identical actively managed exchange-traded funds. Both come with pros and cons. So, what should you consider before modifying your portfolio? Russ Kinnel is the director of ratings for Morningstar Research Services. Here’s my conversation with the FundInvestor newsletter editor.

Thanks for being here, Russ.

Russel Kinnel: Glad to be here.

Open-End Funds vs. Active ETFs

Hampton: Let’s start with what’s similar and different between open-end funds and active ETFs.

Kinnel: Similarities are you get a diversified portfolio generally. Similar regulatory structure, usually the same fund companies are running the ETFs and open-ends. Where they differ are ETFs have tax advantage. They don’t have to distribute capital gains. ETFs don’t have to pay service fees, so they tend to have lower expenses, not always, but they tend to have lower expenses. And ETFs trade minute to minute, whereas open-end funds, you just get the day-end closing price.

Advantages of Active ETFs

Hampton: And active ETFs are growing in popularity. Can you describe some of their advantages?

Kinnel: They have the lower fees and the better tax situation. They also have daily transparency, which matters to some people but not to others. But it’s probably the tax advantage that’s the biggest difference, because actively managed strategies tend not to be that tax-efficient, whereas an index fund, whether it’s open-end or ETF, it’s going to be pretty tax-efficient. But active, they’re not so tax-efficient, so that tax edge is a big deal.

Appeal for Day Traders

Hampton: But there are some pros that would appeal more to a day trader versus a buy-and-hold investor, right? Can you tell us about those?

Kinnel: That’s right. Being able to trade minute to minute. So if, say, you’re a day trader who actually has an opinion on where the market’s going to go from now to an hour from now, that appeals to you. If you really want to move quickly, that appeals. And then, of course, the daily transparency also might appeal to a day trader. I think a long-term investor, like me, I don’t really care about being able to sell in the next 20 minutes.

Disadvantage of Active ETFs

Hampton: Some big mutual funds don’t have an ETF sibling. Talk about that disadvantage and any other cons.

Kinnel: That’s right. The really big mutual funds, active, at least, do not have an ETF counterpart. And that’s in part because ETFs can’t close, and so, a lot of the big mutual funds have closed because they have capacity issues. But if you then open up an ETF counterpart, now you’re kind of saying we can’t close at all. And so it’s not really a practical solution if you’re already really big. So that’s why some funds like a Fidelity Growth Company does not exist in the ETF form.

Which Investors Should Consider Swapping Mutual Funds for ETF Counterparts

Hampton: Now, someone may still have fresh on their minds their capital gains bill from last year. Should they consider swapping their mutual fund for an ETF? What do you think, Russ?

Kinnel: So if you’re in a taxable account, you definitely want to think about tax implications. However, if you already have an open-end fund and you’re thinking about switching to its ETF counterpart, the problem is you may incur more taxes in switching. It’s probably not a good idea unless you know you’re not going to have to pay any more taxes. But it’s really good idea if you’re thinking about a new fund that you’re going to add to your portfolio. It’s definitely worth checking to see, if you like an open-end fund, is there an ETF counterpart that’s very similar to it because that’s definitely going to work for you over the long haul.

Comparing Open-End Funds and Active ETFs on Key Factors

Hampton: And you researched open-end funds and active ETFs based on fees, performance, portfolio, and aftertax returns. Which of these factors provided an edge, and why?

Kinnel: The active ETFs tended to be lower cost, and therefore that showed up for the most part in performance. So if you saw a 20-basis-point lower fee, then they might have a 20-basis-point better performance. But then after taxes where that’s magnified because it’s not just 20 basis points, maybe the open-end fund had a 5% distribution and the active ETF had none, and so the advantage really grew for aftertax returns.

How T. Rowe Price Funds Compare With ETFs

Hampton: And you compared several T. Rowe Price funds and ETFs in the FundInvestor newsletter. What did you find?

Kinnel: For the most part, T. Rowe Price ETFs are more or less a clone of their open-end fund. They have the same name. Their performance is very similar, with one significant exception, which is T. Rowe Price Capital Appreciation, which is David Giroux’s very large asset-allocation fund. And which they’ve actually closed to new investors. So what they did in order to have an ETF version is they said, we’re just going to do the equity sleeve. So you don’t get the allocation and the fixed-income elements of the open-end fund. Giroux’s good at all three of those elements. You just get the equity. So the equity fund is obviously going to be more volatile than the allocation fund. But you’re still tapping Giroux, and you’re getting it at a lower cost, so there’re definitely some advantages with the ETF, too.

Hampton: Is that one of the funds you own?

Kinnel: That’s right. I own that fund because the open-end version is closed.

Fidelity Funds vs. ETFs Performance

Hampton: You’re going to get in there, Russ. How did Fidelity funds and ETFs fare in their head-to-head matchup?

Kinnel: For the most part, they were pretty tight. The ETFs tended to do a little better again because of fees, with one interesting exception, Fidelity Total Bond. The open-end fund actually beat the ETF. I’m not completely sure about why that was, but I think it may be different cash flows or it could be that maybe there were some securities that wouldn’t fit in the ETF because they’re not traded enough, or some other issues like that. And so maybe they had a little of that in the open-end fund. So, one reason or the other, that fund actually beat its ETF counterpart.

Capital Group’s Different Approach to Their Funds vs. ETFs

Hampton: American Funds ETFs are labeled under the parent company name, Capital Group. Can you talk about the performance between the funds and ETFs there?

Kinnel: Capital Group seems to be running its ETFs a little bit differently from its open-end funds. There’s a clear counterpart, but sometimes the managers are different. Sometimes the mandate’s slightly different. So they may have different performance, but they’re fairly new. They’re only about a year old. So we really can’t draw much of a conclusion yet about the performance. But my expectation is performance will be a little more different between the two than say the T. Rowe where they seem to be spot-on clones.

Decision Expected From SEC on ETF Share Class Requests

Hampton: So something to watch for 2025. I want to close our conversation about the anticipated ruling from the SEC. Many fund companies are asking for permission to offer an ETF share class for their mutual funds. What would this mean for the firms and investors?

Kinnel: This was something pioneered by Vanguard. They have a number—their index funds have ETFs as a share class. Essentially, that allows them to wash the capital gains through the ETF and therefore benefit the open-end investors by not distributing gains. And there’s a lot of fund companies who want to do the same thing. The SEC hasn’t signed off yet. If they do sign off, then that is kind of a game changer because at least for those funds, it’ll be leveling the field on the tax situation. Now, the ETF share class may still be cheaper than the fund. So they may still have that advantage, but it may really level the playing field. So it’s definitely something to watch out for.

Hampton: And I know you will. Thanks for coming to the table and sharing your latest insights on the fund industry.

Kinnel: You’re welcome.

What’s New in the Markets

Hampton: Here’s the markets in brief for the week ahead. The markets will be closed on Monday, Jan. 20, in honor of the Dr. Martin Luther King Jr. holiday. They’re set to reopen on Tuesday. Investors will hear from a trio of regional banks that day. Fifth Third, Zions, and Key Corp banks will report their fourth-quarter earnings, and Netflix is expected to unveil its Q4 results after the bell. Meanwhile, the company is competing to become the next sports streaming superstar. Matthew Dolgin is a senior equity analyst for Morningstar Research Services. We talked about what investors should expect from Netflix’s upcoming earnings and his outlook for the stock.

Welcome back to the podcast, Matt.

Netflix’s Message to Competitors

Matthew Dolgin: Thanks, Ivanna.

Hampton: Netflix is becoming a sports destination. Let’s run it off. WWE Raw debuted this month. The streamer carried two NFL games that featured a Beyoncé halftime show during a Ravens-Texans game. What message is Netflix sending to cable TV and other streamers?

Dolgin: Yeah, I don’t think Netflix’s point is to send a message, but the message that they are receiving is that Netflix is in the game. And I’d say more so than the rivals, the leagues are the ones that should be most interested in this. And the first place that we’ll see this probably for major sports rights is with the NFL. The NFL’s contract with its current TV partners goes through 2033, but it has an opt-out in 2029 and then 2030 for Disney, the last remaining partner. And if Netflix is a player, that makes it more likely the NFL wants out and wants to renegotiate. And then the rivals have to determine, are these sports rights really worth it to us? At what point do they get too high to be valuable to us? And are we going to compete with Netflix if it bids it up? So it will be interesting if Netflix gives further signs that it’s more into this game and looking for more regular programming as opposed to some of these one-offs that it’s had so far, at least as far as major sports.

Too Early to Judge Live Sports Push

Hampton: And we just hit 2025, and you’re already bringing up 2029. Something to watch for sure. So it’s probably too early to score Netflix on their sports moves at this point, especially live sports. What do you think of what they’ve done so far?

Dolgin: Well, you’re right, it’s too early to score. And I’d say there’s a couple of reasons, although the viewership numbers have been pretty good, and that’s encouraging. But the reasons it’s too early are, first, we don’t know how things will look when things settle down. So right now, these sports are still novelties, even with WWE Raw, which it has on a weekly basis, we’re two weeks in. The first week was a big event; it brought people in. The question is, do more people view when it becomes the regular thing? The same thing with the NFL; at this point, it’s just the Christmas Day games. They’re kind of novelties. The second thing that makes it too early to tell is we have yet to see how Netflix monetizes these. So longer term, WWE, some of these less major sports, maybe they do get bigger viewership in the US. For the NFL, if it were to become a bigger player in the NFL or other major sports, the question is, can Netflix monetize better?

So with its data on viewers, can it generate more ad revenue than traditional TV partners could generate? And then as far as expanding the viewership base, probably internationally is where it could have the bigger imprint, especially, like for the NFL, which has a smaller imprint globally right now, but Netflix, with its global reach, may be able to bring more viewers into the fold globally. So those would be the two areas we’d be looking for to see how much traction Netflix gets there and whether sports becomes an attractive type of programming for because generally in the industry, we’ve been skeptical about how valuable sports are for the partners. But maybe Netflix will be different, and we’ll see.

How Can Netflix Increase Profits?

Hampton: That’s an interesting point because NFL does host those games. Like it had a game in Brazil. They have games over in Europe. So that’ll be interesting.

Dolgin: They’re sure looking to expand internationally, and Netflix could be a key to doing that.

Hampton: Let’s switch to Netflix crackdown on password-sharing. That boosted subscriber growth and revenue growth. What other areas could Netflix tap to boost profits?

Dolgin: To us, advertising really is the key because some of those factors that you mentioned are waning and past. And so it does need the next thing. We question how much more penetration it can get, especially in the US. So advertising is the key. It’s had a really good uptake on its ad-supported plans that it’s offering, but it’s not yet generating a lot of advertising revenue on those. And so as it reaches a greater scale with ad-supported viewers, it should be able to do that to a much greater extent. And that will be the key because we think it needs something, and that should be probably the biggest area where there’s upside that it hasn’t been able to tap so far.

What to Watch for From Netflix’s Earnings Report

Hampton: Netflix is scheduled to report earnings next week. What are you looking for to determine whether they had a successful Q4 and full year?

Dolgin: At this point, unless the quarter is disastrous, it’s almost, which is by the way almost inconceivable, it’s almost impossible they don’t have a really successful 2024. The year has been so good, better than almost anyone would have imagined. As far as the fourth quarter goes, more important than the results, we’d say, is the outlook, the guidance that the company gives for 2025 and signs that it’s seeing in its business. As for results, if you get midteens revenue growth, if you still have profit margins above 20%, it’s a fine quarter, and like I said, 2024 has been a good year. But as we were talking about, we think some of the tailwinds that it has had have now passed. And what is that next thing? So does management tell us that advertising will be a bigger factor in 2025 for revenue. It’s probably the last quarter that we see subscriber numbers because the firm’s going to stop disclosing those. But how much have those, or have they, decelerated further? They decelerated in the third quarter. Again, it’s been a really good run for a while. How much is that slowing? So how much does that carry into 2025 revenue? What is the next thing that gives us confidence that you can maintain a really high growth rate? And then we expect profits to basically follow along with the rate of revenue growth.

Morningstar’s Outlook on Netflix Stock

Hampton: And what’s your outlook for Netflix stock?

Dolgin: We continue to think the stock is overvalued. We think the company is best in breed. It is far above competitors not only in streaming, but really in media in general. But there’s a right price for everything. As we were talking about, Netflix had a lot of tailwinds in 2024. They’re not going to be there anymore. They need something to pick up that mantle, whether it’s advertising revenue, whether it’s something else. If we don’t see it continuing with the type of growth that investors have gotten accustomed to recently, and we don’t think that there is something that’s going to keep it at that extent, but if we don’t see that, we think the stock could be disappointed. And so, yeah, we see it overvalued right now.

Hampton: Matt, thank you for coming to the table and sharing your insights on Netflix ahead of earnings.

Dolgin: It’s always great to be with you, Ivanna.

Hampton: That wraps up this week’s episode. Thanks for watching and making this show part of your day. Subscribe to Morningstar’s YouTube channel to see new videos about investment ideas, market trends, and analyst insights. Thanks to Senior Video Producer Jake Vankersen, Associate Multimedia Editor Jessica Bebel, and Customer Service Representative Ava Koros. I’m Ivanna Hampton, lead multimedia editor at Morningstar. Take care.