Why are exchange traded funds better than mutual funds?
And, in general, ETFs tend to be more tax efficient than index mutual funds. You want niche exposure. Specific ETFs focused on particular industries or commodities can give you exposure to market niches.
ETFs have several advantages for investors considering this vehicle. The 4 most prominent advantages are trading flexibility, portfolio diversification and risk management, lower costs versus like mutual funds, and potential tax benefits.
What are the advantages and disadvantages of exchange-traded funds versus mutual funds? Exchange-traded funds can be traded during the day, just as the stocks they represent. They are most tax effective, in that they do not have as many distributions. They have much lower transaction costs.
Passive, or index, ETFs generally track and aim to outperform a benchmark index. They provide access to many companies or investments in one trade, whereas individual stocks provide exposure to a single firm. As such, ETFs remove single-stock risk, or the risk inherent in being exposed to just one company.
With a mutual fund, you buy and sell based on dollars, not market price or shares. And you can specify any dollar amount you want—down to the penny or as a nice round figure, like $3,000. With an ETF, you buy and sell based on market price—and you can only trade full shares.
You're tax sensitive
ETFs and index mutual funds tend to be generally more tax efficient than actively managed funds. And, in general, ETFs tend to be more tax efficient than index mutual funds.
Mutual funds are usually actively managed, although passively-managed index funds have become more popular. ETFs are usually passively managed and track a market index or sector sub-index. ETFs can be bought and sold just like stocks, while mutual funds can only be purchased at the end of each trading day.
Mutual funds are priced once a day at the net asset value and they're traded after market hours. ETFs are traded throughout the day on stock exchanges just as individual stocks are. ETFs often have lower expense ratios and are generally more tax-efficient due to their more passive nature.
In a nutshell, ETFs have fewer "taxable events" than mutual funds—which can make them more tax efficient.
| ETFs | Mutual Funds | |
|---|---|---|
| Pricing | Determined by market | Net asset value (NAV) |
| Tax Efficiency | Usually tax efficient due to less turnover and fewer capital gains | Not as tax efficient due to more turnover and greater capital gains |
| Automatic Investing | Not available | Yes, for investments and withdrawals |
What are the advantages and disadvantages of an exchange traded funds versus mutual funds explain your answer?
| Feature | Mutual funds | ETFs |
|---|---|---|
| Brokerage commissions | Often $0, but may range up to $50 | Typically $0 |
| Sales commissions (loads) | Often none, but sometimes 1 or 2 percent | None |
| When you can trade | Priced at the end of the trading day | Can be purchased throughout the trading day |
| Tax efficiency | Lower | Higher |
ETFs can be less expensive to own than mutual funds. Plus, they trade continuously throughout exchange hours, and such flexibility may matter to certain investors. ETFs also can result in lower taxes from capital gains, since they're a passive security that tracks an index.
For instance, some ETFs may come with fees, others might stray from the value of the underlying asset, ETFs are not always optimized for taxes, and of course — like any investment — ETFs also come with risk.
The single biggest risk in ETFs is market risk.
ETFs are set up to protect investors from capital gains taxes better than most mutual funds can.
ETF trading generally occurs in-kind, meaning they are not redeemed for cash. Mutual fund shares can be redeemed for money at the fund's net asset value for that day. Stocks are bought and sold using cash.
*ETFs typically have higher daily liquidity and lower fees than mutual fund shares, making them an attractive alternative for individual investors.
ETFs or "exchange-traded funds" are exactly as the name implies: funds that trade on exchanges, generally tracking a specific index. When you invest in an ETF, you get a bundle of assets you can buy and sell during market hours—potentially lowering your risk and exposure, while helping to diversify your portfolio.
The administrative costs of managing ETFs are commonly lower than those for mutual funds. ETFs keep their administrative and operational expenses down through market-based trading. Because ETFs are bought and sold on the open market, the sale of shares from one investor to another does not affect the fund.
While these securities track a given index, using debt without shareholder equity makes leveraged and inverse ETFs risky investments over the long term due to leveraged returns and day-to-day market volatility. Mutual funds are strictly limited regarding the amount of leverage they can use.
Why are ETFs riskier than mutual funds?
In general, ETFs can be more risky than mutual funds because they are traded on stock exchanges. Their value can fluctuate throughout the day in response to market conditions. This means that if the market takes a dip, the value of your ETF could drop quickly, and you could experience significant losses.
Key Takeaways
Both can track indexes, but ETFs tend to be more cost-effective and liquid since they trade on exchanges like shares of stock. Mutual funds can offer active management and greater regulatory oversight at a higher cost and only allow transactions once daily.
Should I invest in ETF for the long term? ETF investing could help you grow money in the long run, thanks to the compounding power. They typically have lower costs than other types of investments. These benefits help you grow money over time.
ETFs are traded throughout the day at the current market price, like a stock, and may cost slightly more or less than NAV. Mutual fund transactions do not include commissions to a brokerage, while some ETF transactions do. (Check with your brokerage for their specific pricing structures).
At least once a year, funds must pass on any net gains they've realized. As a fund shareholder, you could be on the hook for taxes on gains even if you haven't sold any of your shares.
