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The Difference Between ETFs and Mutual Funds

You have mentioned Exchanged Traded Funds (ETF’s) in a number of your articles. Could you explain the difference between an ETF and a Mutual Fund?

Exchange-traded-funds (ETF’s) have been around for a while. The first one of any significance in the U.S. was the Standard & Poor’s Depository Receipts fund, symbol SPY, introduced in early 1993. It designed to track the S&P 500 index.

Basically, ETFs combine two things: the diversified investment feature of mutual funds with the advantage of being tradable throughout the day.

They are “exchange-traded” funds because they trade on the stock exchange and are bought and sold through any brokerage firm at any time during the trading day, their prices constantly changing with the underlying index or sector they’re designed to track.

Overall, I think the overall advantages of ETF’s outweigh the disadvantages for the average investor.

ETF advantages over typical mutual funds include:

  • The ability to get in or out of them immediately in a fast moving market, rather than having to wait for the price at the market’s close, as with a regular mutual fund.

  • Lower expense ratios because most are index or sector funds and they typically have lower marketing and distribution fees.

  • The absence of minimum investment requirements, minimum holding periods or early-withdrawal fees.

  • The ability to employ leverage (by buying a leveraged ETF), even in most IRAs and 401K plans where leveraging through the use of margin loans is prohibited by law.

  • The ability to take “inverse” positions for market corrections (by buying an inverse ETF), even in most IRAs and 401K plans where short-selling is prohibited because short-selling also involves loans (borrowing the stock to sell short).

  • Freedom to buy any ETF through any brokerage firm, rather than being restricted to only those mutual funds available at a specific fund family.

  • The ability to use limit orders, protective stops, margin and to even sell them short.

ETF disadvantages include:

  • Some ETFs may have low trading volume, the difference between the “bid” and “ask” price can be excessive, requiring some care in placing orders for those.

  • There is a brokerage commission, which although very small at discount brokerage firms, can add up in small portfolios if a lot of trades are made.

  • Depending on investor demand, they can sometimes be trading at either a premium or a discount to their actual net asset value.

  • They do not always exactly mimic the underlying index’s price moves. (That is also true of end-of-day priced index mutual funds).