How ETFs Differ From Mutual Funds

By Jeffrey Jackson

Costs ETFs, being traded on an exchange, are subject to a brokerage commission. Typical brokerage fees range from $10-20, however can be as low as low as $3 with an online discount broker. On the contrary, mutual funds obtained from the fund company directly do not charge any brokerage fees.

Mutual funds, when compared to ETFs, have much higher expense ratios. Mutual funds also have higher share-holder related expenses. ETFs aren't required to maintain cash reserves for redemptions, fund cash redemptions nor invest cash contributions. Expenses for mutual funds can range from 1% - 3% whereas ETFs are much lower and range from 0.1% - 1%. As those mutual fund related costs begin to compound they make a considerable difference in the long run. It's also important to take note of the front or back end loads charged by mutual funds, Exchange Traded Funds have no such loads.

The structure of ETFs in the U.S. makes them much more tax efficient than mutual funds. Whenever a mutual fund realizes a capital gain not balanced out by a loss, a mutual fund must distribute a capital gain to its investors. This can happen whenever it sells portfolio securities, whether to reallocate its investments or to fund shareholder redemptions. Those who re-invest those gains in more shares of the same fund are required to pay the capital gains tax.

ETFs act conversely. As any other stock they are sold on the stock market, instead of being redeemed by shareholders as is the case with mutual funds. Capital gains are only realized when a share of stock is sold or there is a change in the original index from an index trade. ETFs have grown in popularity because of their tax advantage over mutual funds.

In the U.K., ETFs can be shielded from the capital gains tax by placing them into a self-invested pension or an individual savings account.

ETFs have the ability to perform like a traditional share of stock with all the flexibility and benefits. Some of the things that can also be done with ETFs are: limit orders, buys on margin, stop-loss orders, options (puts and calls) can be written against them, and short selling. None of the aforementioned can be done with mutual funds.

Unlike ETFs, mutual funds only permit purchasing and selling at the end of the day, and at the the fund's closing price. This disables all benefits from stop-loss orders and most brokers don't allow them. Because an ETF is continually priced throughout the day, its stock-like liquidity makes it possible for investors to make trades during normal trading hours. - 31970

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