As investors dip into the financial markets to pick out the best fit, many will choose investment options from the fund market, comparing traditional open-end mutual funds to the relatively new exchange traded funds.
Potential investors should understand the benefits and weigh the drawbacks as they fill out a diversified investment portfolio.
For starters, the main difference between ETFs and open-end funds is how investors enter and exit the options, writes William Baldwin for Forbes.
Mutual funds cash out sellers and admit new investors once per day at net asset value, which is calculated from 4 p.m. closing prices of the securities in the portfolio. ETF shares, on the other hand, are traded throughout the day, like any company stock, through a normal stock brokerage account.
Investors may not need to pay a commission or sales fee to enter or exit a mutual fund, at least for no-load funds that are distributed directly by the investment company. ETF investors, though, may have to pay a commission fee to trade ETF shares, like trading company stocks. However, a number brokerage platforms are now offering commission-free trades on ETFs as a way to incentivize investment activity in ETFs on the free trading programs. For instance, investors are not charged to trade Vanguard ETFs on the Vanguard brokerage platform, Charles Schwab doesn’t charge for various ETFs and TD Ameritrade hosts over 100 commission-free ETFs. [Six Popular Commission-Free ETF Trading Platforms]
Since ETFs are traded throughout the trading day, traders should also watch the bid/ask spread. While two ETFs may have a bid/ask spread of one penny, ETFs trade at different prices so a low-priced ETF with a one penny spread will cost more than high-priced securities. Consequently, Hoffstein suggests investors to convert the spread into basis points since it provides a better represents of the overall percentage of an ETF’s price. According to Morningstar data, ETFs with more assets have tighter bid-ask spreads, and U.S. stocks have tighter spreads than less-liquid securities like bonds or international stocks that trade in different time zones. [The Total Cost of Investing in ETFs]
Short-term investors should be more mindful of the bid/ask spread and commission fees as it can cut into overall returns. However, for more long-term investors, the bid/ask spread is less of a worry.
On the other hand, mutual funds may impose restrictions and/or penalties on short-term traders to discourage speculative moves.
Instead, those with a longer investment horizon are more concerned about overall expense ratio. Most long-term investors have gravitated toward ETFs because of the fund’s cheaper fees. U.S.-listed passively managed ETFs have an average expense ratio of 0.55% and the cheapest ones come with a 0.04% fee, according to XTF data.
Moreover, long-term investors may enjoy ETFs for the more favorable tax consequences. When an investor sells a mutual fund, the active fund has to sell securities to raise cash, which triggers a taxable event and issues capital gains for all investors. ETFs, on the other hand, employ a type of “in-kind” transaction where ETF shares are swapped for baskets of underlying securities, or vice versa, so no cash is involved and no taxable event is triggered. [How ETFs Are Traded]
However, ETFs are not completely immune to capital gain distributions. For instance, if an index is updated, the fund will have to do some buying and selling.
Baldwin argues that investors can disregard the tax efficiency if one is buying in a tax-sheltered account, but if you are buying in a taxable account, investors may be better off with ETFs.
For more information on ETFs, visit our ETF 101 category.
Max Chen contributed to this article.