Unlike mutual funds, ETFs do not sell holdings in exchange for cash, which would trigger a taxable event. Instead, the ETFs undergo a creation and redemption process in which market makers, authorized participants or large institutional investors swap a basket of securities from the underlying benchmark index for ETF shares, or vice versa. [ETF ‘In-Kind’ Redemptions Help Limit Capital Gains]
Investors may also trade ETFs throughout the trading day, similar to any other stock on an exchange. Due to the intraday trading, ETF shareholders also benefit from greater liquidity, which help diminish implicit costs and add to more accurate pricing.
“Even as ETFs are more cost-effective than mutual funds overall, investors should still evaluate each fund’s expense ratio, liquidity and the role it will play in a diversified portfolio,” Stein said. “There are other ways to invest successfully, of course, but relying on an all-ETF portfolio offers more potential to turn a small but consistent edge—reduced expenses—into a substantial increase in wealth over the long haul.”
For more information on ETFs, visit our ETF 101 category.
Max Chen contributed to this article.