What Are ETFs? How Are They Different From Mutual Funds?

Exchange-traded funds or ETFs are a relatively unexplored investment idea, especially for retail investors. However, thanks to their low costs and better tax treatment, ETFs are gaining their fair share of interest.

Since ETFs are more similar than different from mutual funds, understanding the key differences between them is important.

ETFs – A Breakdown

ETFs are funds that own underlying assets and divide their ownership into shares. The underlying assets can range from bonds to foreign currency to shares to oil futures and much more. ETF shareholders are the indirect owners of these assets. With low-costs access, investors, big or small, can build institution-caliber portfolios with better transparency.

ETFs have one of these three legal structures:

  • Exchange-Traded Open-End Index Mutual Fund
  • Exchange-Traded Unit Investment Trust
  • Exchange-Traded Grantor Trust

ETFs And Mutual Funds – The Differences

Though a lot in common, there are subtle, yet significant differences between ETFs and mutual funds.

  • Trading Process and Flexibility

One of the primary differences between ETFs and mutual funds lies in the trading process and flexibility offered by the former. Just as in stocks, investors can trade in ETFs throughout the trading day unlike mutual funds where a purchase can be made only at the fund’s Net Asset Value, published at the end of the day.

The demand from investors during the trading time determines the prices of ETFs. The fact that investors can’t purchase them at the closing NAV gives ETFs a major advantage. They are immediately tradable, that cushions against the risk of significant price difference between the time of investment and trade.

  • Operating Expenses and Cost Advantage

Most ETFs deploy passively managed strategies that bring down their internal expenses. The expense ratios range from 0.10% to 1.25%. Product acquisition cost is another important consideration.

Generally, ETFs are cost-effective. While mutual funds often have marketing and distribution expenses, ETFs are free from such loads. Though there can be exceptions – it is advisable for investors to examine the relative costs – yet the structural differences between the products make ETFs more economical.

  • Tax Advantages

The tax treatment of investment vehicles is a major consideration for investors. Because of frequent trading, there is a high tax on capital gain for mutual funds which is comparatively lower for ETFs.

The way ETFs are created and redeemed make them more tax-efficient than mutual funds. Creation of fewer taxable events than mutual funds add to their tax effectiveness.

  • Share Trading Account

The difference in account stems from the nature of trading between ETFs and mutual funds. Since ETFs are traded in the stock market unlike mutual funds, which are purchased from fund houses, they warrant a share trading account.

Data availability is another area where ETFs score over mutual funds. While ETF holdings can be freely seen on a day-to-day basis, mutual fund holdings are disclosed monthly or quarterly. Overall, ETFs are great investment vehicles for both small and big investors. However, knowing the potential pitfalls helps investors towards tidy profits.

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