Why Choose Exchange Traded Funds over Mutual Funds?

Exchange traded funds have been providing an alternative to mutual funds since the early 1990s. Between 2002 and 2007, investment in exchange traded funds increased by  500%, even though mutual funds still hold the lion’s share of the market. Mutual funds and exchange traded funds might seem very similar, but they have some very important differences associated with them. Both instruments are collections of individual stocks or bonds, which provide investors with automatic diversification from the risks of holding individual assets. They also both offer a large degree of liquidity.

Major Differences

Mutual funds are either actively or passively managed. in actively managed mutual funds, a fund manger, or a team of managers, selects, buys, and sells assets from the fund on a regular basis. Passively managed funds generally have a  a methodology or formula for managing the fund instead. Passively managed funds often track individual market indexes. Exchange traded funds can also be either actively or passively managed. However, like the name indicates, they can be traded on an exchange, and easily traded, like a stock. ETFs often track indexes, commodities, or baskets of assets. Unlike mutual funds, but like with stocks, the price of ETFs fluctuates throughout the day. Mutual funds have their Net Asset Value calculated on a daily basis.

Expense Ratios

An expense ration is the annual expense that a money management firm pays to manage its expenses expressed as a percentage of its assets. ETFs generally have lower expense ratios than mutual funds do, because ETFs are generally very cheap to manage. When you buy or sell an ETF, you pay the same broker commission you would when  you buy or sell a stock. Mutual funds usually have much higher expense ratios because they have to pay their fund managers, send out monthly statements, compensate salesmen, and provide various other costumer services. They are also  often subject to to  12(b)-1 fees for marketing expenses. Mutual funds have an average 1.56% expense ratio. Meanwhile. ETFs  have an average 0.40% expense ratio.

Tax Efficiency

ETFs are considered more tax-efficient than mutual funds. ETFs have low portfolio turnover and low capital gains distributions. Since mutual funds tend to be actively managed, they incur the costs associated with high turnover. Even passively managed mutual funds often make capital gains distributions, which are heavily taxed.

Timely Reporting of Holdings

The holdings of ETFs are reported on a daily basis. This means ETFs tend to be very transparent and easy to analyze. Mutual funds on the other hand are only required to report their holdings twice a year. This makes mutual funds a far less transparent investment.

Price Certainty

Since mutual funds are only priced once day, and after the close of trading, investors are not aware of the executed price until the market closes. Also, submitted orders might not be executed until one or two days after the fact. This is not the case with ETFs, which are traded and priced throughout the day.

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