Ask TheStreet: ETFs vs. Index Mutual Funds

Other cost considerations: ETFs have no minimum investment requirements (though you do buy in whole shares as opposed to dollar amounts) and no fees for early withdrawals. However, with an ETF, you do have to pay the bid-ask spread, which can vary.

Pricing: Both ETFs and index mutual funds use the net asset value of the underlying holdings to calculate share price, but with ETFs, the price can be influenced by market forces, such as supply and demand. When this happens and an ETF starts trading at a premium or discount to its NAV, arbitrage mechanisms are used to bring the price back in line.

Tax efficiency: ETFs are generally more tax-efficient than mutual funds. When a large investor wants to cash out of a mutual fund, the portfolio manager often has to sell shares in the fund to raise the money. This generates a capital gain distribution, which is taxable to shareholders.

ETFs, though, are sold on the open market, so when an investor wants to cash out, he can just sell his shares without affecting other shareholders. (In some cases, an authorized participant -- typically large institutional organizations, such as market makers or specialists -- can exchange shares of the ETF for the underlying stocks, and since this is an "in-kind" transaction, no capital gain distributions are triggered.)

ETFs may, however, incur capital gain distributions if, say, the fund needs to sell securities when it rebalances. Because of the ETF structure, though, capital gains can often be minimized or avoided altogether.

Capabilities: Because ETFs are securities, investors can use them in many of the same ways they would stocks. For example, they can set limit orders or sell ETFs short. Many ETFs have options listed on them as well.

Although there are various other differences between ETFs and index mutual funds, the ones above are the biggies.