November 27, 2013

One of the investment choices that has become increasingly popular in the last few years is the exchange traded fund (ETF). ETFs and mutual funds (including index funds ) share some similarities, but there are some very important differences, and these differences explain why ETFs are becoming so popular amongst traders.

ETFs and mutual funds are similar in that the idea is to bundle together different securities. They are set up so that you get instant diversity. Instead of investing in a wide variety of investments one at a time, you can invest bundled.

You can invest all-market funds that track the performance of the entire stock market, or you can invest in bond funds that follow different bond securities. There are also opportunities to invest in ETFs or mutual funds that concentrate on specific sectors or even asset classes.

Even though there are these similarities, though, its important to realize that there are also very real differences:

When Trading Takes Place

ETFs actually trade on stock exchanges the same that stocks do. As a result, you can trade an ETF at any time, and you pay the same flat rate for the transaction as you would for a stock. Mutual funds, on the other hand, are traded only at the end of the day, according to the net asset value (NAV), and they are not traded the same way stocks are. In many cases, the flat rate for trading a mutual fund with a broker is higher than the rate you pay for trading an ETF.

Operating Expenses

Depending on the type of mutual fund you have, the operating expenses vary. If you have an actively managed fund, you could pay 2% per year for your fund. Index funds typically have lower costs, though, since they just own shares of all the securities on a particular index, so there isnt a lot of management. ETFs, though, usually have much lower operating expenses. Its possible to find ETFs with expenses as low as 0.15% or even less.

Taxable Transactions

One of the issues that many mutual fund investors run into is the triggering of taxable events. When securities are bought and sold in mutual funds, its possible for capital gains to be realized. You might have to pay taxes on the transactions that take place within the fund, even though you havent bought or sold your own mutual fund shares. With ETFs, its different, with the creation and redemption of shares taking place on an in-kind basis. This means that they are not considered sales, and you dont end up with capital gains in many cases. As a result, an ETF can have a more favorable tax impact for your situation.

Other Differences

Even though you probably wont see a sales load with an index mutual fund, other mutual funds often charge sales loads. This can erode your returns. An ETF, on the other hand, never charges a sales load.

Additionally, many mutual funds require an investment minimum. Its common for major mutual fund brokers to require between $1,500 and $5,000 as a minimum to invest in a particular mutual fund. While you might have to have a minimum to open an account at a specific broker, you dont need a minimum investment for a particular ETF. If you open an account with a broker that doesnt require a minimum investment, you can invest in an ETF with whatever you have. Even with brokers that dont have minimums to open an account, you might still have a minimum to invest in a specific mutual fund.

For many people, the ease of trading ETFs – and their cost-efficiency – make them desirable choices. You still need to be careful though, and do your due diligence with research. You can still lose your money, and you want to make sure that you are careful about which ETFs you invest in.

Do you like ETFs or mutual funds better? Leave a comment and let us know!

This article was originally published November 21, 2012.

Last updated by Miranda .

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