Exchange-traded funds (ETFs) were once described as the new kids on the investment block, but today they are giving traditional mutual funds a run for their money. Both ETFs and mutual funds are viable choices for investors. But, with many mutual funds and ETFs available on the market, it's important for investors to familiarize themselves with the differences between products to ensure they are making appropriate investment decisions. While mutual funds and ETFs share similar traits, there are differences between the two that investors must consider when deciding which to use. Read on to find out more.

Tutorial: Investing In Exchange-Traded Funds

Legal Structure of Funds
Both mutual funds and ETFs can vary in terms of their legal structure. Mutual funds can typically be broken down into two types.

  • Open-Ended Funds
    These funds dominate the mutual fund marketplace in terms of volume and assets under management. With open-ended funds, purchases and sales of fund shares take place directly between investors and the fund company.
    There's no limit to the number of shares the fund can issue; as more investors buy into the fund, more shares are issued. Federal regulations require a daily valuation process, called marking to market, which subsequently adjusts the fund's per-share price to reflect changes in portfolio (asset) value. The value of the individual's shares is not affected by the number of shares outstanding.
  • Closed-End Funds
    These funds issue only a specific number of shares and do not issue new shares as investor demand grows. Prices are not determined by the net asset value (NAV) of the fund, but are driven by investor demand. Purchases of shares are often made at a premium or discount to NAV. (For related reading, see Closing Funds: Investment Protection Or Trap? and Open Your Eyes To Closed-End Funds.)

Legal Structure of ETFs
An ETF will have one of three structures:

  • Exchange-Traded Open-End Index Mutual Fund
    This fund is registered under the SEC's Investment Company Act of 1940, whereby dividends are reinvested on the day of receipt and paid to shareholders in cash every quarter. Securities lending is allowed and derivatives may be used in the fund.
  • Exchange-Traded Unit Investment Trust (UIT)
    Exchange-traded UITs are also governed by the Investment Company Act of 1940, but must attempt to fully replicate their specific indexes, limit investments in a single issue to 25% or less, and set additional weighting limits for diversified and non-diversified funds. UITs do not automatically reinvest dividends, but pay cash dividends quarterly. Some examples of this structure include the QQQQ and Dow DIAMONDS (DIA).
  • Exchange-Traded Grantor Trust
    This type of ETF bears a strong resemblance to a closed-ended fund but, unlike ETFs and closed-end mutual funds, an investor owns the underlying shares in the companies that the ETF is invested in, including the voting rights associated with being a shareholder. The composition of the fund does not change; dividends are not reinvested but instead are paid directly to shareholders. Investors must trade in 100-share lots. Holding company depository receipts (HOLDRs) are one example of this type of ETF.

Trading Process
ETFs offer greater flexibility than mutual funds when it comes to trading. Purchases and sales take place directly between investors and the fund. The price of the fund is not determined until end of business day, when net asset value (NAV) is determined. An ETF, by comparison, is created or redeemed in large lots by institutional investors and the shares trade throughout the day between investors like a stock.

Like a stock, ETFs can be sold short. Those provisions are important to traders and speculators, but of little interest to long-term investors. But, because ETFs are priced continuously by the market, there is the potential for trading to take place at a price other than the true NAV, which may introduce the opportunity for arbitrage. (To learn more about arbitrage, read Arbitrage Squeezes Profit From Market Inefficiency.)

Due to the passive nature of indexed strategies, the internal expenses of most ETFs are considerably lower than those of many mutual funds. Of the more than 900 available ETFs listed on Morningstar in 2010, those with the lowest expense ratios charged about .10%, while those with the highest expenses ran about 1.25%. By comparison, the lowest fund fees range from .01% to more than 10% per year for other funds. (For more on mutual fund feeds, read Stop Paying High Fees.)

Another expense that should be considered is the product acquisition costs, if any. Mutual funds can often be purchased at NAV, or stripped of any loads, but many (they are often sold by an intermediary) have commissions and loads associated with them, some of which run as high as 8.5%. ETF purchases are free of broker loads. (For related reading, see The Lowdown On No-Load Mutual Funds.)

In both cases, additional transaction fees are usually assessed, but pricing will largely depend on the size of your account, the size of the purchase and the pricing schedule associated with each brokerage firm. Clients of advisors who hold institutional accounts for their clients tend to benefit from lower trading costs, often as low as $9.95 per ETF purchase or $20 for mutual funds. Additional cost considerations should be given if you plan to use dollar-cost averaging to buy into the funds or ETFs, because frequent trading of ETFs could significantly increase commissions, offsetting the benefits resulting from lower fees.

Tax Advantages and Disadvantages
ETFs offer tax advantages to investors. As passively managed portfolios, ETFs (and index funds) tend to realize fewer capital gains than actively managed mutual funds. ETFs are more tax efficient than mutual funds because of the way they are created and redeemed. For example, suppose that an investor redeems $50,000 from a traditional Standard & Poor's 500 Index (S&P 500) fund. To pay that to the investor, the fund must sell $50,000 worth of stock. If appreciated stocks are sold to free up the cash for the investor, then the fund captures that capital gain, which is distributed to shareholders before year-end. As a result, shareholders pay the taxes for the turnover within the fund. If an ETF shareholder wishes to redeem $50,000, the ETF doesn't sell any stock in the portfolio. Instead it offers shareholders "in-kind redemptions", which limit the possibility of paying capital gains. (For more on tax saving, read Money Saving Year-End Tax Tips.)

Liquidity is usually measured by the daily trade volume, which is generally expressed as the number of shares traded per day. Thinly traded securities are illiquid and have higher spreads and volatility. When there is little interest and low trading volumes, the spread increases, causing the buyer to pay a price premium and forcing the seller into a price discount in order to get the security sold. ETFs, for the most part, are immune to this. ETF liquidity is not related to its daily trading volume, but rather to the liquidity of the stocks included in the index. (For related reading, see Diving In To Financial Liquidity.)

Broad-based index ETFs with significant assets and trading volume have liquidity. For narrow ETF categories, or even country-specific products that have relatively small amounts of assets and are thinly traded, ETF liquidity could dry up in severe market conditions, so you may wish to steer clear of ETFs that track thinly traded markets or have very few underlying securities or small market caps in the respective index.

ETF Survivability
A consideration before investing in ETFs is the potential that fund companies will go bust. As more product providers enter the marketplace, the financial health and longevity of the sponsor companies will play a greater role. Investors should not invest in ETFs of a company that is likely to disappear, thereby forcing an unplanned liquidation of the funds. The results for investors who hold such funds in their taxable accounts could be an unwelcome taxable event. Unfortunately, it is next to impossible to gauge the financial viability of a startup ETF company, as many are privately held. As such, you should limit your ETF investments to firmly established providers or market dominators to play it safe.

The Bottom Line
As products are rolled out, investors tend to benefit from increased choices and better variations of product and price competition among providers. It's important to note the differences between ETFs and mutual funds, and how those differences may impact your bottom line and investment processes.

Related Articles
  1. Mutual Funds & ETFs

    Should Investors Take a BITE Out of This New ETF?

    ETF BITE offers a full menu of restaurants. Is now the right time to invest?
  2. Financial Advisors

    5 Things All Financial Advisors Should Know About ETFs

    Discover five things all financial advisors should know about ETFs, including when ETFs may be a better choice for your clients than mutual funds.
  3. Stock Analysis

    The Top 5 ETFs to Track the Nasdaq in 2016

    Check out five ETFs tracking the NASDAQ that investors should consider heading into 2016, including the famous PowerShares QQQ Trust.
  4. Investing Basics

    Fee-Only Financial Advisors: What You Need To Know

    Are you considering hiring a fee-only financial advisor or one who is compensated via commissions? Read this first.
  5. Investing

    Time to Bring Active Back into a Portfolio?

    While stocks have rallied since the economic recovery in 2009, many active portfolio managers have struggled to deliver investor returns in excess.
  6. Mutual Funds & ETFs

    The Democratization of the Hedge Fund Industry

    The coveted compensations of hedge fund managers are protected by barriers of entry to the industry, but one recent startup is working to break those barriers.
  7. Investing

    What a Family Tradition Taught Me About Investing

    We share some lessons from friends and family on saving money and planning for retirement.
  8. Retirement

    Two Heads Are Better Than One With Your Finances

    We discuss the advantages of seeking professional help when it comes to managing our retirement account.
  9. Retirement

    How a 401(k) Works After Retirement

    Find out how your 401(k) works after you retire, including when you are required to begin taking distributions and the tax impact of your withdrawals.
  10. Chart Advisor

    Now Could Be The Time To Buy IPOs

    There has been lots of hype around the IPO market lately. We'll take a look at whether now is the time to buy.
  1. How does the risk of investing in the Internet sector compare to the broader market?

    Investing in the Internet sector carries more risk than investing in the broader market. However, the Internet sector also ... Read Full Answer >>
  2. What did Warren Buffett mean when he said, “Diversification is protection against ...

    Billionaire investor Warren Buffett famously stated that "diversification is protection against ignorance. It makes little ... Read Full Answer >>
  3. Can a 401(k) be taken in bankruptcy?

    The two most common types of bankruptcy available to consumers are Chapter 7 and Chapter 13. Whether you file a Chapter 7 ... Read Full Answer >>
  4. When can catch-up contributions start?

    Most qualified retirement plans such as 401(k), 403(b) and SIMPLE 401(k) plans, as well as individual retirement accounts ... Read Full Answer >>
  5. Who can make catch-up contributions?

    Most common retirement plans such as 401(k) and 403(b) plans, as well as individual retirement accounts (IRAs) allow you ... Read Full Answer >>
  6. Can you have both a 401(k) and an IRA?

    Investors can have both a 401(k) and an individual retirement account (IRA) at the same time, and it is quite common to have ... Read Full Answer >>

You May Also Like

Hot Definitions
  1. Cyber Monday

    An expression used in online retailing to describe the Monday following U.S. Thanksgiving weekend. Cyber Monday is generally ...
  2. Bar Chart

    A style of chart used by some technical analysts, on which, as illustrated below, the top of the vertical line indicates ...
  3. Take A Bath

    A slang term referring to the situation of an investor who has experienced a large loss from an investment or speculative ...
  4. Black Friday

    1. A day of stock market catastrophe. Originally, September 24, 1869, was deemed Black Friday. The crash was sparked by gold ...
  5. Turkey

    Slang for an investment that yields disappointing results or turns out worse than expected. Failed business deals, securities ...
  6. Barefoot Pilgrim

    A slang term for an unsophisticated investor who loses all of his or her wealth by trading equities in the stock market. ...
Trading Center