Like mutual funds, exchange-traded funds (ETFs) represent a share of ownership in a pool of stocks, bonds, and/or other securities. However, while they are quite similar in a general sense, there are a number of differences between ETFs and mutual funds in regard to trading, investment strategy, tax efficiency, and trading costs.
Trading
Mutual funds trade once per day. No matter when you place your sell/buy order during market hours, your trade will be filled at the end of the day. That means one price per day for mutual funds.
ETFs, on the other hand, trade like a stock. You can trade them throughout the day (within market hours) and their price adjusts in real time based on the supply and demand of the marketplace.
Investment Strategy
While there exist some actively-managed ETFs, most are passive strategies that track an index of securities. According to AdvisorShares, an issuer of active ETFs, there was just $5.2 billion invested in 41 active ETFs as of February 2012 compared to the $939 billion invested in all equity ETFs. So when you purchase an ETF, the odds are that you are investing passively, buying a fund that tracks a particular market index and that only makes changes when the underlying index changes.
In contrast, the universe of mutual funds offers significant options for both active and passive investors. While this active vs. passive distinction between ETFs and mutual funds may erode in the future as active ETFs grow in popularity, it remains a major differentiator between the two types of funds at the present time.
Tax Efficiency
Both mutual funds and ETFs are required to distribute their gains to shareholders, but ETFs are structured in such a way that they can easily minimize their year-end capital gain distributions or even eliminate them all together.
When a mutual fund receives redemption requests (i.e. sell orders) from its shareholders, it must sell securities to raise the cash to pay them. Such transactions could result in capital gains being realized if those securities are in the black. In such a case, any capital gain would ultimately be passed on to the remaining shareholders via a capital gain distribution at the year’s end. In essence, a portion of tax management is largely out of the control of the fund manager.
With ETFs the manager has the option of fulfilling redemption requests in the shares of the investments it owns. This is known as an “in-kind” redemption. It is a not a taxable event, and it allows ETF managers to fulfill redemption requests without selling shares, which would be a taxable event. It also allows the manager to transfer shares with a lower cost basis, thereby ridding the ETF of securities with larger unrealized capital gains. As a result, only 20 of 756 (2.6%) traditional equity ETFs paid capital gain distributions in 2011 according to a study by IndexUniverse.
Fees & Trading Costs
Both ETFs and mutual funds charge management fees. ETFs tend to charge lower fees than mutual funds as a whole, but that is because ETFs tend to utilize lower-cost passive strategies as described above. When you compare the management fees of ETFs to index mutual funds, there is little difference.
While ETFs have low management fees, they also have additional trading costs due to the fact that they trade in real time like a stock. Most brokers will charge a trading commission to buy and sell ETFs, and market makers will exact their toll via the bid/ask spread, which represents the difference in price that they are offering to the buyer and seller in each transaction.