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ETFs are a type of exchange-traded investment product that offer investors a way to pool their money in a fund. This fund makes investments in stocks, bonds, or other assets and, in return, receive an interest in that investment pool. Unlike mutual funds, however, ETF shares are traded on a national stock exchange. ETFs are not the same thing as mutual funds. Generally, ETFs combine features of a mutual fund, which can be purchased or redeemed at the end of each trading day at its net asset value per share with the intraday trading feature of a closed-end fund, whose shares trade throughout the trading day at market prices. To put the difference between mutual funds and ETFs in perspective, imagine a day like Black Monday, October 19, 1987 when the stock market dropped 22.6%. If you had owned ETFs (which were actually not sold in 1987), you could have sold your ETF shares at any time during the day for their value at the moment, which was higher as the market was falling than it was when the day ended 22% lower. Had you owned a mutual fund and sold during the day, the brokerage would have taken your order when you said sell, but the sell price would have been calculated at the end of the day based on the net asset value, which in a 22% drop, would have been very low. The ability to sell the ETF immediately for its price right then as opposed to getting the end-of-the-day value for the mutual fund could save money in the event of a rare market crash.
Mutual funds are still the cornerstone investment of many retirement plans, but ETFs have been gaining in popularity in the past few years. Which is a better choice for your investment portfolio? If you are a long-term, buy-and-hold investor with little interest in trading, you are probably fine with highly rated, no-load mutual funds held by a reputable fund manager since the ability to trade often and quickly is not a characteristic that is important to you. If you prefer to buy and sell more frequently, ETFs offer greater tradability, lower costs, diversification, and transparency and therefore may work better for your objectives.
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Exchange-traded funds, or ETFs, are similar to mutual funds because both instruments bundle together securities to offer investors diversified portfolios. Typically anywhere from 100 to 3,000 different securities can make up a fund. Yet, the two investment types are marked by significant differences.
ETFs trade throughout the trading day, like stocks, while mutual funds trade only at the end of the day at the net asset value (NAV) price. Most ETFs track to a particular index and therefore have lower operating expenses than actively invested mutual funds. Thus, ETFs may improve your rate of return on investments. In addition, ETFs have no investment minimums or sales loads, unlike traditional mutual funds, which often have both. Most indexed mutual funds will not have sales loads.
ETFs create and redeem shares with in-kind transactions that are not considered sales. Thus, taxable events are not triggered. Redemptions create tax events in mutual funds, but they do not create tax events in ETFs. When a forced sale of stock occurs, mutual funds record and distribute higher levels of capital gains than ETFs. In addition, ETFs have greater tax efficiency due to a structure that allows them to substantially decrease or avoid capital gains distributions altogether. This difference can greatly affect the overall rate of return, even if an ETF and mutual fund both track the identical index.
|Trade during trading day||Trade at closing NAV|
|Low operating expenses||Operating expenses vary|
|No investment minimums||Most have investment minimums|
|No sales loads||May have sales load|
One of the primary differences is that an ETF, exchange-traded fund, trades throughout the day. One can buy or sell at any time the market is open. A mutual fund trades at the closing price for the day with everyone getting in and out at the same price. Secondary differences include the costs associated, commissions for transactions (or sales charges for some mutual funds), and for closed-end funds whether it is trading at a premium or discount to the underlying assets.