The Difference Between Exchange Traded Funds and Mutual Funds
August 20th, 2011 | Author: weissheiss
Exchange traded funds (ETF) and mutual funds are diversified portfolios of securities, representing an ownership of assets that generate earnings. A very distinguishing characteristic for both funds is their diversification. It gives investors the opportunity to place their money in investments with not entirely correlated returns, which significantly reduces the volatility in the value of the portfolio.
Both are powerful investment tools that help investors to achieve their profit objectives. It is very important for the investor to be familiar and have a fundamental understanding of the strengths, weaknesses, opportunities, and treats related to each investing fund.
ETFs offer several advantages over mutual funds. First of all, an ETF is an investment vehicle that allows investors to trade portfolios as they do shares of stocks on an exchange. Therefore, ETFs trade continuously- their price can change every second, while traditional fund types can be bought or sold once a day- the transaction is completed after the market closes. Like other shares, but unlike mutual funds, ETFs can be sold short or be traded through market order, limit order or stop- loss order. All these trading choices serve as risk management tools that eliminate the price uncertainty involved with placing an order for a mutual fund and not knowing what will be the actual price until the market day is over.
ETFs are typically cheaper than mutual funds too. Investors who buy or sell an ETF place an order through a broker rather than buying directly from the fund. In this way, the fund saves the cost of marketing itself directly to small investors, which translates into lower management fees. Even more, mutual funds face additional odious fees like: sales charges, redemption fees, fund operating expenses, and recurring fees used to pay for the expenses of marketing the fund to the public.
ETFs also offer a potential tax advantage over their more traditional cousin. When mutual funds investors decide to redeem their share, the fund must sell securities of the underlying portfolio to meet the redemption. This can cause large capital gains taxes, which are distributed among the remaining shareholders. In fact, investors end up paying tax twice on their mutual fund investment: once a year and then when the shares are sold and capital gains are incurred. In contrast, ETFs are tax- friendly. Similar to shares, the ETF investors are taxed only one time- when shares are sold. Therefore, the amount that would have been paid for taxes can continue to accumulate wealth for the ETF investors.
Despite all listed above advantages the exchange-traded funds have over mutual funds, there is a significant disadvantage that should not be neglected- lack of professional money management. One of the greatest benefits of mutual funds is the ability to delegate the portfolio management to investment professionals. This frees the individual from many of the administrative burdens of owning individual securities and reduces the risk involved with easy loss of money due to bad investments in poorly chosen stocks. As the old adage goes, “In order to win you have to risk loss.”
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