Exchange-traded funds (ETFs) first appeared on the investment scene in 1993, when the SPDR S&P 500 ETF (NYSEARCA: SPY) was launched. Since then, the number of ETFs has increased to over 1,600, as of February 2015, and their popularity among investors has soared. While there are similarities between ETFs and mutual funds, there are also important differences that investors must consider before making investment decisions.
A Growing Variety of ETF Products
The first ETFs that were introduced in the 1990s were passively managed index ETFs designed to replicate the performance of a particular index, such as the S&P 500. Today, investors can choose from ETF products that include index ETFs, fixed-income ETFs, actively managed equity-based ETFs, sector ETFs focusing on a particular industry or geographic region, and leveraged or inverse ETFs. Average investors with small investment portfolios and large hedge funds managing billions of dollars can find suitable ETFs to meet their investment objectives.
Pricing of ETFs
An ETF can contain hundreds or even thousands of securities, but its shares trade exactly like the shares of an individual stock. The shares fluctuate in price intraday on a stock exchange, and they have bid and ask prices. Shareholder demand and market volatility can influence the market price of an ETF, which can result in the shares trading at a premium or a discount to the ETF's net asset value (NAV). In contrast, shares of a mutual fund are priced at their NAV once a day, at 4 p.m. The intraday pricing of ETFs means that ETF investors can control the timing of their trades, so they have the potential for outperformance. Intraday pricing can be particularly important to short-term investors and traders.
Flexibility in Buying and Selling ETFs
Investors place orders for ETFs through brokerage accounts, which allow them to take advantage of the different types of buy and sell orders. For example, an investor can place a limit order, a stop-limit order or a short-sale order. He can also buy on margin if he has a margin account with his brokerage firm. This buy-and-sell flexibility, along with intraday pricing, gives the ETF investor the potential to leverage his investment returns. Many ETFs also have put and call options, which investors can buy and sell to hedge the risk in their portfolios. Mutual fund investors do not have similar order options when they buy and sell fund shares. Every investor who purchases shares of a mutual fund on a given day will pay the same NAV price, calculated at 4 p.m.
Many investors want to know which securities an ETF portfolio holds. While mutual funds only report their holdings on a monthly or quarterly basis, ETFs offer daily disclosure of their portfolio holdings, including their top 10 holdings, industry sector allocations and geographic allocations. ETFs also disclose their performance for both the market price and the NAV of the shares. All of this data is readily available on financial websites.
Since ETF shares trade on the secondary market through various exchanges, each buy trade is matched with a corresponding sell trade. The ETF portfolio manager does not sell any stock in the portfolio when the fund's shares trade. However, when an investor wants to redeem $10,000 from a mutual fund, the fund must sell $10,000 worth of stock from its holdings to pay that redemption. If the fund realizes a capital gain with the sale, that capital gain is distributed at year end among the shareholders. Mutual fund shareholders must pay taxes on the net capital gains realized from the turnover within the fund during the course of a year. Therefore, ETFs are more tax-efficient than mutual funds, since the investor can decide when to sell, realize capital gains or offset capital losses. He is in control of the tax consequences.