The Basic Differences between ETFs & Actively Managed Mutual Funds
Exchange Traded Funds (ETFs) are a type of investment quickly gaining in popularity. But what are ETFs? Investors like ETFs because they combine some benefits of both mutual funds and regular stocks. The most common ETFs are indexed to yield return that match a given market, sector or industry, similar to passive-indexed mutual funds. With so much buzz around ETFs, it’s important to understand exactly how they work before investing.
by Michelle E. Wells CFA®
What are ETFs?
Most ETFs are investments where investors can get exposure to a specific market segment, industry, or sector, without creating a portfolio of individual stocks or bonds. For example, an S&P 500 ETF would hold a portfolio of securities that would mirror the performance of the S&P 500. In this way, an ETF is like an indexed-mutual fund.
The most apparent way in which the two differ is how they trade and are priced. ETFs trade like regular stocks on the listed stock exchanges and as such, are priced throughout the day; whereas open-ended mutual funds trade at the end of the day when the markets have closed and are priced based on the fund’s net asset value (NAV), which is calculated at the end of the day based on the closing price of the mutual fund’s underlying securities.
Generally ETFs provide much greater transparency for investors since they tend to report daily their underlying positions, whereas open-ended mutual funds provide this information less frequently (usually quarterly). While not important for everyone, ETFs’ higher transparency offers investors the opportunity to make timely investment decisions, especially if the ETF is actively managed versus passively indexed.
Most ETFs provide a tax advantage over mutual funds due to their structure. The purchase or sale of an ETF does not trigger a taxable event for the ETF, only for the holder of the ETF at the time of sale. Redeeming mutual fund shares may require the fund manager to liquidate underlying assets to raise the necessary cash for redemptions; that may cause tax consequences that get passed onto to all holders of the Mutual Fund at the time that capital gains are distributed, not just the redeemer of the shares.
When compared to an actively managed mutual fund, most indexed ETFs do not issue capital gains either as they trade less frequently. Mutual funds are required to pass their trading capital gains through to investors, whereas most ETFs are passively managed and as such the investor only recognizes gains upon the sale of their position. This flexibility is good for investors who want to have more control over the timing of their tax liability.
ETFs, both active and passive, generally have lower fees than open-ended active mutual funds, especially when compared to mutual funds with front-end loads, redemption fees or 12b-1 fees. While ETFs may incur a commission as they are traded in brokerage accounts on listed stock exchanges, the landscape here is also changing as brokerage commissions are falling across many brokerage firms and some are even offering a limited number of commission free ETFs making the cost to invest in these new products even more appealing as they do not carry additional fees (front-end loads, redemption fees or 12b-1s).
For sophisticated investors, some ETFs even offer option writing capability to hedge their ETF positions. Mutual funds do not offer listed options on their shares.
The landscape for ETFs is rapidly changing as it moves from a low-cost passively indexed investment option for investors to a relatively cheap alternative to actively managed mutual funds. With new ETFs being created as quickly as they are being dismantled, it is important to seek out professional guidance into investing in the right ETF investment option that meets your investment objectives.
Sources: SPDR University, Ishares, Vanguard
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