ETFs (Exchange-Traded Funds) and mutual funds are investment vehicles that enable investors to pool their money to buy a collection of stocks or bonds. This makes it practical for the average investor to diversify their holdings across a large number of companies or entities. Mutual funds can be actively or passively managed. Generally, ETFs are passively managed and are designed to represent a specific index or category of securities, similar to an index mutual fund. ETFs are especially useful in focusing on narrow sectors of the market that frequently aren’t offered by mutual funds. ETFs can be especially useful to invest in a specific country or industry sector.
Mutual funds and ETFs differ in how they are traded. Mutual funds are bought and sold through a mutual fund company. ETFs are bought and sold on the market, between investors. Shares in a mutual fund are traded based on the price at the close of the day. ETFs can be traded throughout the day, anytime the market is open. This is similar to the manner in which individual stocks are traded.
Generally, ETFs have lower fees than mutual funds because of lower overhead costs. This is especially true when comparing ETFs to actively managed mutual funds. However, when you purchase an ETF you must pay a brokerage fee every time a transaction is made. Mutual funds may be more efficient if you are planning to dollar cost average, or buy shares over a period of time.
Due to structural differences, ETFs can provide greater tax efficiencies than mutual funds. ETFs are traded on the market between investors, much like individual stocks. When investors buy and sell shares of ETFs, shares are exchanged between one another; there is no taxable sale of stocks or bonds within the ETF. On the other hand, mutual funds are traded within a mutual fund company. If several investors decide to sell, the manager may be forced to sell stock or bonds within the fund to cover the redemption. This is a taxable event that may result in capital gains that must be passed on to the shareholders.
Additionally, the structure of an ETF allows for the creation and redemption of shares with in-kind transactions. Capital gains taxes are avoided because there is no taxable sale of stocks or bonds within the ETF when an in-kind redemption is done.
Finally, ETFs are generally tax efficient because they are passively managed, similar to an index fund. Passively managed investments track to an index and don’t do a lot of trading. With less trading, the investor should incur less capital gains while holding the ETF. Mutual fund investors can also minimize their exposure to capital gains by purchasing index funds and tax efficient funds that do minimal trading. Both Mutual Funds and ETFs that invest in bonds or dividend paying stocks must pass interest and dividend income on to shareholders.