How are ETFs Different from Mutual Funds?

S&P Capital IQ

You are interested in exchange-traded funds, but you'd like to learn how to use them properly. This article examines the characteristics that set exchange-traded funds apart from mutual funds.

Investors have probably heard of exchange-traded funds (ETFs), but they may not understand how ETFs work or what benefits or drawbacks they may have over mutual funds. Such information can lead to more intelligent and balanced investment decisions. This article provides an overview of how ETFs are structured, managed, bought, and sold. Along the way we point out the key areas in which ETFs differ from mutual funds -- e.g., how and when they can be traded, operating expenses, and potential tax treatment. We round out the article with a simple comparison chart that highlights the main features.

Key Points

You've probably heard of exchange-traded funds (ETFs), but you may not have a clear idea of how they work, how they differ from mutual funds, or how they might fit in your investment portfolio. Here's your chance to take a closer look at ETFs and examine the characteristics they share with mutual funds as well as those that set them apart.

Mutual Funds that Trade like Stocks

Although ETFs and mutual funds both register with the SEC as investment companies, they are structured and operate quite differently.

Mutual funds pool investors' money to purchase a portfolio of securities. Each investor owns shares, which represent a portion of the holdings of the fund. Shareholders buy and sell shares based on the fund's NAV -- net asset value -- which is calculated daily and fluctuates as fund holdings and shares outstanding change. Some mutual fund shares can be purchased from fund companies directly, while others are sold through brokers, banks, financial planners, or insurance agents. If you purchase mutual fund shares through a third party, there is a good chance you will pay a sales commission, or load.

When describing ETFs, it may help to think of them as mutual funds that trade like single stocks. ETF shares are created when an institutional investor or "authorized participant" deposits a specified block of securities with the fund. This "basket" of stocks reflects the composition of an index, such as the S&P 500 or the Nasdaq 100. Individual investors can buy and sell ETF shares only after they are listed on an exchange such as the New York Stock Exchange (NYSE). Unlike mutual funds that must be purchased or sold at their end-of-day NAV, ETFs can be bought and sold in real time at prices that change throughout the day. Although ETFs still calculate an end-of-day NAV, intraday prices are based on investor demand. ETFs can thus be used for certain hedging strategies typically associated with stocks, such as buying on margin and selling short.

Comparing Costs

One of the key selling points of exchange-traded funds is cost. ETF expense ratios are generally lower than no-load index mutual funds and are significantly lower than actively managed mutual funds.1 For instance, the average expense ratio is 0.60% for ETFs, 0.75% for index funds, and 1.24% for actively managed funds.2

These cost savings can be significant, especially for long-term investors. Although ETF investors will pay a brokerage commission on a per-trade basis to buy or sell shares, the savings from lower expenses can help offset these transaction costs.

Tax Consequences

One major tax advantage that sets ETFs apart from mutual funds is that ETF shareholders are not affected by the trading activity of fellow investors. For instance, mutual fund managers may be forced to sell portfolio holdings to meet the redemption demands of certain fund investors, resulting in an unexpected capital gain or loss to all shareholders. With ETFs, since trading takes place on an exchange between investors, the fund doesn't need to sell stock to meet redemptions, thereby avoiding unforeseen tax events. In addition, the generally low portfolio turnover rate of ETFs contributes to their lower operating costs.

It should be noted that mutual funds and ETFs are required to make annual capital gains distributions to investors, which may be caused by index rebalancing. But as noted above, for ETF investors capital gains distributions are never caused by redemptions in the fund.

Fund Transparency

Today, investors are increasingly demanding more transparency with regard to fees, portfolio holdings, and other operational features. By design, ETFs and index mutual funds deliver greater transparency than actively managed mutual funds because their composition and performance are tied directly to the indexes they mimic. Individuals can easily gauge the performance of their investment by referring to the index it follows. By comparison, the holdings in actively managed funds are subject to change and are less easy to monitor.

Balancing Act

Perhaps the biggest concern for investors with regard to ETFs is derived from one of their greatest attractions. ETFs are so easily bought and sold through a broker or by accessing an online trading account that investors could be tempted to trade too frequently and eliminate any tax or cost advantages due to transaction costs. Therefore, as with any other investment, ETFs should be considered carefully and used only as part of a tailored investment strategy.

At-a-Glance Comparison

Attribute Exchange-Traded Fund Mutual Fund
Trading Buy or sell on an exchange at "real-time" prices throughout the day Buy or sell once a day at the closing net asset value
Can be bought on margin/sold short Yes No
Purchase/sale Buy through brokers or online trading account Buy direct from fund company, through a third-party (broker, bank, financial advisor), or fund supermarket
Expenses Expense ratio is generally lower than index or actively managed mutual funds; brokerage commissions are charged on a per-transaction basis May be subject to front-end or back-end sales loads and annual management expenses, including 12b-1 fees; however, some funds may not charge a sales load
Tax consequences Same as for individual stocks Same as for individual stocks; may force unwanted capital gains distribution due to trading activity of other fund shareholders

Points to Remember

  1. Exchange-traded funds and mutual funds both register with the SEC as investment companies, but they are structured and operate quite differently.
  2. ETFs are often described as mutual funds that trade like single stocks.
  3. Unlike mutual funds that are purchased or sold only at the end of the trading day at their closing NAV, ETFs are bought and sold on an exchange throughout the day at "real-time" prices.
  4. ETFs can be used for certain hedging strategies typically associated with stocks, such as buying on margin and selling short.
  5. ETF expense ratios are generally lower than no-load index mutual funds and are significantly lower than actively managed mutual funds.
  6. Unlike mutual funds, ETF transactions do involve brokerage commissions.
1 An expense ratio represents the percentage of fund assets paid for operating expenses and management fees, including 12b-1 fees, administrative fees, and all other asset-based costs incurred by the fund except brokerage and trading costs.

2 Based on the average expenses for all funds and ETFs tracked by Morningstar as of December 31, 2011. Expense ratios are calculated from the actual expenses paid if available; otherwise, they are calculated from the stated expense ratio in the fund's prospectus.
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