Since their emergence in the 1970s, mutual funds have permeated the financial industry to become one of the premier investment vehicles for both individual and institutional investors. But experts have often panned the majority of traditional mutual fund offerings, pointing out that they can be expensive, illiquid and relatively inefficient when it comes to taxation. A new breed of funds, however, arose in the early 1990s and still provides many of the same advantages of traditional funds without several of these drawbacks. Exchange Traded Funds (ETFs) are mushrooming in popularity and have begun to supplant their traditional cousins in some areas.

Cost Comparison
One of the prime advantages of ETFs is that they typically cost a great deal less than traditional funds. Many mutual funds charge a sales load that is assessed either at the time of purchase (for A shares) or charged according to a declining schedule if the fund is sold within a certain period of time (with B shares). C shares investors will usually pay a small amount up front and then another smaller amount if they redeem the shares after a year. Traditional mutual funds also charge ongoing management fees called 12b-1 fees that can equal up to a percent or more of each investor's money per year.

Although there are no-load funds that do not have sales charges, even these funds typically charge management fees of some sort (the average cost for a stock fund is just under 1.5%). ETFs never have sales charges and usually charge little or nothing in the way of ongoing management fees, but investors must pay a brokerage commission to buy and sell them just like a stock or any other publicly-traded security. Investors who have limited means may therefore want to consider ETFs because of their lower overall cost. Investors who make small monthly systematic investments such as $50 per month, however, should remember that there is usually a minimum brokerage charge for their monthly purchase; even a $9.95 commission would constitute a substantial percentage of the amount invested. Those in this category may be wise to stick with a traditional fund that will charge a more appropriate percentage for even a small amount of money.

Trading Advantages
Investors who are on a tight budget should also consider that since ETFs trade like stocks, they can be bought and sold on margin and sold short. They can also be purchased at a limit price and have trailing stop loss orders placed under them for protection. Traditional fund investors are at the mercy of the markets and can only buy in when the fund's daily price is set at 4 p.m. EST each day. ETFs are therefore popular with market timers and day traders who seek efficient ways to get into and out of the markets quickly and cheaply. Even low-cost, no-load traditional index fund investors can only place a single buy or sell order each day. Investors with limited means who wish to invest in a specific subsector will also probably be able to find an ETF that focuses on precisely their objective, while providing all the advantages of brokerage trading at minimal cost. Small investors can also participate in sophisticated inverse strategies with special ETFs that invest in instruments that move inversely to the markets.

Tax Advantages
Another key advantage of ETFs is their lower distribution rate of capital gains. Traditional open-end funds that are actively managed often post substantial capital gains distributions every year around November. But most ETFs invest in a set basket of securities that focus on a sector, subsector or benchmark index such as the S&P 500, which typically have very low portfolio turnover. This allows investors to save money on taxes by not having to pay for embedded capital gains each year.

The Bottom Line
ETFs have continued to grow in popularity with both investors and money managers because of their lower costs and greater versatility. Investors who are on a tight budget can often get more bang for their buck out of these instruments than they can from traditional funds. For more information on ETFs, consult your stockbroker or financial advisor.

Related Articles
  1. 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.
  2. 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.
  3. Chart Advisor

    Copper Continues Its Descent

    Copper prices have been under pressure lately and based on these charts it doesn't seem that it will reverse any time soon.
  4. Mutual Funds & ETFs

    Buying Vanguard Mutual Funds Vs. ETFs

    Learn about the differences between Vanguard's mutual fund and ETF products, and discover which may be more appropriate for investors.
  5. Mutual Funds & ETFs

    ETFs Vs. Mutual Funds: Choosing For Your Retirement

    Learn about the difference between using mutual funds versus ETFs for retirement, including which investment strategies and goals are best served by each.
  6. Mutual Funds & ETFs

    How to Reinvest Dividends from ETFs

    Learn about reinvesting ETF dividends, including the benefits and drawbacks of dividend reinvestment plans (DRIPs) and manual reinvestment.
  7. Mutual Funds & ETFs

    Best 3 Vanguard Funds that Track the Top 500 Companies

    Discover the three Vanguard funds tracking the S&P 500 Index, and learn about the characteristics and historical statistics of these funds.
  8. Forex Fundamentals

    How to Buy Chinese Yuan

    Discover the different options that are available to investors who want to obtain exposure to the Chinese yuan, including ETFs and ETNs.
  9. Mutual Funds & ETFs

    ETF Fees: Why BlackRock is the Latest to Cut Them

    Low expense ratios are a big selling point for ETFs, but are they being focused on too much?
  10. Chart Advisor

    Is This The Beginning Of A Downtrend In Home Builders?

    Falling lumber prices and weakness on the charts of home builders suggest that the next leg of the trend could be downward.
  1. Should mutual funds be subject to more regulation?

    Mutual funds, when compared to other types of pooled investments such as hedge funds, have very strict regulations. In fact, ... Read Full Answer >>
  2. Do ETFs pay capital gains?

    Exchange-traded funds (ETFs) can generate capital gains that are transferred to shareholders, typically once a year, triggering ... Read Full Answer >>
  3. How do real estate hedge funds work?

    A hedge fund is a type of investment vehicle and business structure that aggregates capital from multiple investors and invests ... Read Full Answer >>
  4. Are Vanguard ETFs commission-free?

    While some Vanguard exchange-traded funds (ETFs) are available commission-free from third-party brokers, a large portion ... Read Full Answer >>
  5. Do Vanguard ETFs require a minimum investment?

    Vanguard completely waives any U.S. dollar minimum amounts to buy its exchange-traded funds (ETFs), and the minimum ETF investment ... Read Full Answer >>
  6. Can mutual fund expense ratios be negative?

    Mutual fund expense ratios cannot be negative. An expense ratio is the sum total of all fees charged by an asset management ... Read Full Answer >>

You May Also Like

Hot Definitions
  1. Take A Bath

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

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

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

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

    The quick ratio is an indicator of a company’s short-term liquidity. The quick ratio measures a company’s ability to meet ...
  6. Black Tuesday

    October 29, 1929, when the DJIA fell 12% - one of the largest one-day drops in stock market history. More than 16 million ...
Trading Center