What is an Exchange Traded Fund (ETF)?

Most investors are familiar with mutual funds, but how familiar are you with their relatives, exchange traded funds, or ETFs? You will make more informed investment decisions when you understand the differences between mutual funds (MF’s) and ETFs. Let’s dive into the basic characteristics and advantages of ETFs.

Similarities Between Mutual Funds and ETFs

First, the similarities: An ETF, like a mutual fund, is a basket of individual stocks or bonds to provide the investor with diversification of their investment dollars. Like MFs, ETFs can be index funds, which attempt to track a particular stock/bond index and are “unmanaged” by an investment manager or actively managed funds. Both offer hundreds of funds to cover virtually all sectors of investments and investor objectives.

Advantages of ETFs

A major difference between MFs and ETFs is in the transaction process: ETFs are bought and sold on the stock exchanges just like individual stocks or bonds. As such, they are subject to “real time pricing.” In contrast, MFs are priced and trade after the markets close each day. So, ETFs give the investor much more control over the securities’ transaction prices.

Another advantage of ETFs is their management fee: Typically, an ETF has a much lower ongoing management fee than a MF, making the ETF considerably more cost efficient.

Also, MFs may require a considerable “minimum initial investment” amount to open the fund while ETFs have no minimum requirement. However, an advantage of MFs over ETFs is the ability to invest on a periodic basis (e.g., fixed dollar amounts each month, or some regular time period).

In addition to the above, ETFs may offer tax advantages. MFs typically distribute capital gains during the calendar year and the investor could be subject to taxation on these distributions.  The ETF investor is in control of capital gains, as the ETFs typically do not issue capital gains. So the investor would not be subject to capital gains until the ETF is sold.

These are some of the basic differences between mutual funds and exchange traded funds. If you would like additional information about ETFs, please contact your advisor.