The upstart exchange traded fund industry is edging into the mutual fund market space as more investors see the benefits of the flexible, low-cost and tax efficient investment vehicle.
While ETFs are often compared with mutual funds, the two fund structures come with different quirks.
“They’re like kissing cousins in many aspects, and too often people have segmented ETFs and mutual funds and made them sound like they’re completely different investment vehicles and approaches,” Joel Dickson, senior ETF strategist at Vanguard, said in the article. “What underlies both is a diversified, commingled, generally low-cost professionally managed investment portfolio.”
ETFs are bought and sold throughout the day on an exchange like normal stocks. Meanwhile, mutual funds are priced at the end of each trading day.
“You have to be careful with ETFs,” Dickson added. “It gives you a lot more flexibility, but that comes with an additional amount of knowledge that you need to have around how they trade, using limit orders instead of market orders, and what the cost might be.”
Active traders benefit from ETFs’ intra-day tradability to capitalize on movements in a number of market segments throughout normal trading hours.
“If you need to actively trade your investment, either with intraday trades, stop orders, limit orders, options or short selling, you should use an ETF, as these are not possible with mutual funds,” Michael Iachini, managing director of ETF research at Charles Schwab Investment Advisory Inc, said in the article.
Unlike mutual funds, ETFs don’t come with sales loads, or fees to buy or redeem assets. The only direct costs an ETF investor has to fork over include the commission fee on trades and annual expenses associated with maintaining the ETF.
Some online brokerage platforms provide commission-free trades on a number of ETFs. [Six Popular Commission-Free ETF Trading Platforms]
Since most ETFs passively track an index, they have lower operating expenses than actively managed mutual funds. According to Morningstar, the average expense ratio of U.S.-listed ETFs is 0.67%, compared to 1.25% for U.S. mutual funds.
“The math that should be done by most investors is the comparison of the relative cost of each,” Ben Johnson, director of passive funds research at Morningstar, said in the article. “The one thing we know for certain that we as investors can control is the cost of investing. The more I can save for myself and not hand over to a broker or money manager, the more money I’ll have socked away for my own purposes further down the road.”
“In general, both index mutual funds and ETFs are tax-efficient, but ETFs have the edge in most cases,” Iachini said. “Actively managed funds tend to be the least tax-efficient, except for those that are managed for tax-efficiency.”
ETFs are tax efficient because most passively track indices and the ETF structure allows the investment to avoid capital gains through “in-kind” creations and redemptions. [Creations & Redemptions]
“The ETF manager isn’t seeking out overvalued or undervalued stocks, continuously buying and selling stocks in an effort to beat the market,” Iachini said. “Without this frequent buying and selling, there isn’t much chance for an ETF to realize capital gains.”
For more information on mutual funds & ETFs, visit our mutual funds category.
Max Chen contributed to this article.