Depending upon the investor, exchange-traded funds may have possible drawbacks. No-load mutual fund investors would need to open a brokerage account and pay commissions to trade. Frequent, small investments that are part of a dollar-cost averaging strategy could prove to be more expensive. Additionally, investors need to understand that passive ETFs are subject to tracking errors, some to a greater degree than others, where the manager may not be able to purchase some illiquid securities in the index and must attempt index replication through sampling the liquid securities in it. Product complexity is always a consideration.
Investors must also understand differences in settlement procedures. Whereas mutual funds settle next-day, ETFs settle in three business days. The investor must have cash on hand to pay for purchases. Retail investors would be more likely to find these differences a challenge than institutional ones. Below is a table that better illustrates the differences between the two financial instruments.
Daily and continuous pricing
Fund redemption at day\'s end
No tax effect of trading on shareholders
Large redemptions may cause capital gains distributions for non-redeeming fund shareholders
In-kind redemption reduces shareholder tax liability
Fund managers limited in their ability to manage taxes due to cash redemptions
Limit, stop limit orders, short selling allowed
No limit order pricing or short selling permitted
May be purchased and sold on margin
No margin trades allowed
Lower expense ratios as client services born by brokerage firms
Expenses tend to be higher due to sales loads
May be purchased in any brokerage account
Fund availability depends on existence of selling agreements with the broker/dealer
Brokerage commissions applicable
transaction costs, load funds through a broker often have sales charge or commission
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