Editor's Note: Ask TheStreet is designed to answer questions about the market, terms, strategies and investment methods. Please email us to ask a question, but keep in mind that we cannot offer specific investment- or stock-related advice.
Can you tell me some of the differences between ETFs and index-based mutual funds? Thanks, G.G.
ETFs resemble index-based mutual funds in that both represent baskets of securities that track the performance of an index. However, there are key differences between ETFs and index funds, including how they trade, what they cost and what they can do.
ETFs are bought and sold through brokers and trade throughout the day on an exchange, like stocks. Because the share price is published throughout the day, traders are able to buy or sell shares as they please.
Index fund shares, on the other hand, are purchased from the holding fund, and share purchases and sales are only priced once a day, at the close of trading.
ETF expense ratios are generally cheaper. For instance, the expense ratio for
Vanguard's Total Stock Market ETF
is .07%, compared with an expense ratio of 0.19% for the firm's
Total Stock Market Index Fund.
But there are two things to consider when it comes to comparing costs. First, many of the newer ETFs coming out are more expensive than the original plain-vanilla products.
Second, because ETFs are bought and sold through brokers, investors have to pay a commission each time they trade. This isn't a big issue for investors who plan on dumping a lot of money into an ETF and letting it sit. But for those who prefer to invest in small, regular increments, the brokerage fees will outweigh the benefit of the lower expenses.
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.
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.
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.
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.