It’s important for investors to understand the key differences between traditional mutual funds (open-end) and exchange-traded funds (ETFs). Each has its advantages and disadvantages. This knowledge can translate into making informed investment decisions. Let’s focus on the key points.
The expense ratios of ETFs are generally lower versus active mutual funds and in some cases, even lower than index mutual funds. Also, ETFs often have lower trading costs versus actively managed funds, due to their low portfolio turnover. The ETF cost savings can be significant, especially for long-term investors. Investing in ETFs will usually result in a brokerage commission, but the savings from lower expense ratios can help to offset these transaction costs. Also, ETFs do not impose back end redemption charges like many mutual funds. Information on specific fees, charges, and expenses is obtained in the fund prospectus.
|MUTUAL FUNDS VS. ETFs||Mutual Funds||Exchange-Traded Funds|
|Continuous trading and pricing throughout the day?||NO||YES|
|Can be bought on margin?||YES||YES|
|Can buy/sell options?||NO||YES|
|Sold by prospectus?||YES||YES|
|Can use in an IRA, 401(k), or another retirement plan?||YES||YES(1)|
|Can be purchased through a traditional or online broker?||YES||YES|
|Minimum investment or share amount required ?||YES (2)||NO(3)|
|Redemption Charges for Early Withdrawals||YES||NO|
|Traded on what exchanges?||N/A||Amex, NASDAQ NYSE Arca|
Fund Transparency and NAV
Actively managed mutual funds report their holdings on a quarterly or semiannual basis, whereas exchange-traded funds disclose their portfolio holdings on a daily basis. This provides ETF investors with a greater degree of financial transparency. The ETF performance and portfolio composition are a reflection of the underlying index. Consulting the index provider’s Website is another way of easily identifying the underlying holdings of an index ETF.
Mutual funds are bought and sold at net asset value (NAV), which is determined by subtracting a fund’s liabilities divided by the number of shares outstanding from the value of a fund’s total assets. All buy and sell transactions are conducted directly with the fund company. In contrast, ETFs are bought and sold on a stock exchange based upon market prices, which fluctuate according to supply and demand.
ETFs generally trade close to their net asset value. It’s rare to see ETFs trading at a large premium or discount to their NAV, but it can happen. Historically, institutions have seen this as an arbitrage opportunity by creating or liquidating creation units. This process keeps ETF share prices closely hinged to the NAV of the underlying index or basket of securities.
Taxes and Portfolio Turnover
Annually, both mutual funds and ETFs are required to distribute dividends and portfolio gains to shareholders. This is usually done at the end of each year and these distributions can be caused by index rebalancing, diversification rules, or other factors. Also, anytime you sell your fund this could generate tax consequences.
For U.S. investors ETFs held in a taxable account with qualified stock dividends and long-term capital gains are typically taxed at 15 percent. Short term gains are levied at federal income tax rates. While ETF distributions tend to be infrequent, tax consequences can be incurred even if an investor decides to hold their shares.
ETFs are renowned for having low portfolio turnover, which is good for investors, because it reduces the possibility of tax gain distributions. Among other benefits, ETF investors are insulated from the activity of fellow shareholders, whereas mutual fund investors aren’t. Mutual fund managers are often forced to sell portfolio holdings to meet the redemption demands of exiting shareholders. Remaining fund shareholders are adversely impacted because they absorb the tax gains and losses triggered by these untimely sales. ETFs avoid this problem because they are bought and sold on an exchange, therefore investors don’t affect the tax consequences of each other.
(1) For employer sponsored retirement plans ETFs may not be available as an investment option. Self-directed retirement plans may offer ETFs and a broader menu of investment choices.
(2) Most mutual funds impose a minimum investment or required dollar commitment, while others wave this requirement.
(3) Exception is Merrill Lynch’s HOLDRs, which can only be bought and sold in 100-share increments.