What is the difference between exchange-traded funds and mutual funds?

By Steven Merkel AAA
A:

Exchange-traded funds, or ETFs, are similar to mutual funds because both instruments bundle together securities in order to offer investors diversified portfolios. Typically over 100, or even up 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 a 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 improve your rate of return on investments. In addition, ETFs have no investment minimums or sales loads, unlike traditional mutual funds, which have both. However, 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.




ETFs
Mutual Funds

Trade during trading day
Trade at closing NAV

Low operating expenses
Operating expenses vary

No investment minimums
Most have investment minimums

Tax-efficient
Less tax-efficient

No sales loads
May have sales load


For more on this topic, read Exchange-Traded Funds: Introduction and Mutual Fund or ETF: Which Is Right for You?

This question was answered by Steven Merkel.

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