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||Forward pricing|
|Exchange traded||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|
Whatever choice investors make, they need to have a clear picture of their objectives and constraints, either through simple data gathering or more elaborate work with an investment advisor who can put together an Investment Policy Statement. Additionally, as with any investment, investors need to understand the risk and return profile of the asset classes in which they plan to invest and how the instruments work. Once they do, the choice of mutual fund or exchange-traded fund is simply a matter of implementation.
Unit Investment Trusts
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