Exchange Traded Funds (ETFs)
An exchange-traded fund (ETF) is best described as a mutual fund that trades like a stock. Like a mutual fund, an ETF represents a basket of stocks (or bonds, commodities, or futures) that trade as one unit. Like a stock, an ETF can be sold short, and can be traded on margin. And, shares can be bought and sold at any time during the trading day. ETFs offer a number of advantages over mutual funds, two of which are lower expense ratios and a higher degree of tax efficiency. While an ETF offers the advantage of diversification that stocks don't, you must still evaluate it to make sure it is appropriate for your investing time horizon, level of risk tolerance, and overall asset allocation. Whether part of an investment or retirement account, ETFs can play an important part in meeting your overall financial objectives.
Net-Asset Value of an ETF
Mutual funds and ETFs trade at a net-asset value (NAV). The NAV of a mutual fund is determined at the end of the trading day by taking the value and quantity of each share of stock held within the fund and dividing it by the number of shares outstanding. A mutual fund only has two prices each day: the price at which it opens and the price at which it closes. ETFs, however, have a value throughout the trading day that is determined by the number of shares bought and sold. Just like a stock IPO, the initial share value is determined when the ETF is launched for public trading. Its price then fluctuates based on supply and demand like that of any share of stock. This can be particularly important if the share price of the ETF is dropping rapidly. The sell order is executed as soon as it's received, regardless of the time of day. A mutual fund, however, can only be redeemed at the end of the day, regardless of when the sell order was placed.
ETFs Offer Instant Diversification
Just like a mutual fund, an ETF can contain hundreds of stocks. For example, ETFs that track the Standard & Poor's 500 Index contain the 500 stocks within the index. Because diversification is one of the most important aspects of investing, ETFs provide a way to take part in multiple market sectors without incurring the added risk of owning just a few stocks.
There is an ETF for almost every category of investing, which is increasingly important for diversification. ETFs for specific countries, currencies, and industries help investors take part in emerging markets and economic growth in other countries.
ETFs Have Lower Fees than Mutual Funds
One of the most important aspects of ETF investing, if not the most important, is the lower expense ratio of owning shares. The expense ratio is the measure of the costs the fund company incurs to operate, manage, and advertise the fund. In other words, all funds come with a "cost of ownership". The expenses are deducted from the fund's assets, which in turn lower the return earned by investors. When money is deducted from the account to cover expenses, less is available to compound and grow. All things being equal, choosing the investments with the lowest expense ratio means higher returns and significantly higher growth over time.
While the actual expense ratio of each ETF will vary by company and the assets in which the fund invests, in general, investors can expect to pay 1% to 2% less in expenses for an ETF than a mutual fund. On average, the expense ratio for an actively managed mutual fund is 1.5%, 0.5% for an index fund, and 0.4% for an ETF. A difference of 1.1% may not seem like much, but it becomes significant as assets grow. An investor who owns a mutual fund worth $100,000 with an expense ratio of 1.5% per year will pay $1,500 to own that fund. But the investor who has an ETF worth $100,000 and pays .4% in annual fees will only pay $400 to own the ETF. At the end of the year, the ETF investor will have $1100 more than the mutual fund investor. The following year, the ETF investor will be earning a return on an additional $1,100, which will further push the value of the ETF ahead of the mutual fund.
ETFs and Tax Considerations
Regardless of the investments held in the ETF, they are considered to be highly tax-efficient investments. ETFs held in tax-qualified accounts are not subject to taxes on gains until the money is distributed after age 59 ½. The tax treatment of an ETF held in a regular brokerage account depends on the underlying investments and the sector to which the ETF belongs. For example, ETFs that hold commodities, precious metals, or currencies are all taxed at different rates, just as they would be if they were held as individual investments.
One of the drawbacks of mutual funds is that an investor does not have control over short- or long-term capital gains taxes. If the fund manager sells a stock for a gain, it triggers a taxable event, which is then passed on to the fund owners. This is why the overall return of actively managed funds, and to some extent index funds, can be several percentage points lower than the pretax return.
ETFs are more tax-efficient because they are allowed to buy and sell shares in a process that is known as "in kind redemption". When the manager of an ETF sells shares, he or she does not receive cash as does a mutual fund manager. The ETF manager redeems shares for other shares. In other words, the stock is replaced, not actually sold. Therefore, ETFs should always be considered for inclusion in investment accounts, especially for investors in high tax-brackets and those who enjoy trading but want to reduce the inherent tax liabilities.
There are no absolutes when it comes to ETF and mutual fund investing. Some investors will prefer a more expensive, actively managed fund if they're uncomfortable with managing their own money, haven't the time for research, or simply prefer the older investment model. But most investors can benefit from owning EFTs instead of mutual funds.
While we've covered the basics of mutual fund investing here, there is much more to maximizing the success of your fund investment strategy. To make sure you're on the right track, contact a licensed financial advisor. It only takes a few minutes, Start Now.
More Mutual Fund Guidance
- Mutual Funds Investment Guide — The complete guide to mutual fund investing.
- Equity and Bond Funds — Understanding how equity and bond funds work.
- Balanced, Index, and Specialty Funds — Comparing balanced, index, and specialy funds.
- Money Market Funds — Explore how money market funds work.
- Best Mutual Funds — Factors affecting mutual fund rates, and how to find the best ones.
- Mutual Funds FAQ — Frequently asked questions about mutual fund investing.