Four Reasons Why Exchange Traded Funds Gain In Popularity Over Mutual Funds

October 31, 2012 by Thomas F. Burke, P.C.

Exchange-traded funds, commonly called ETFs, are investment funds that trade like stocks on stock exchanges. Most ETFs track an index, such as a stock index or a bond index. Exchange-traded funds began trading in 1993, but in recent years they've been gaining in popularity against more mature mutual funds. The number of existing ETFs has increased dramatically so now investors can choose from hundreds of them.

Only authorized participants, large institutional investors, buy or sell shares of an ETF directly from the fund manager. Individuals can buy and sell ETFs through a broker or a brokerage account.

When shares of a traditional mutual fund are purchased, the net asset value serves much like a stock price -- it's the price at which shares are bought or sold from the fund company. At a traditional fund, the NAV is set at the end of each trading day. ETFs work differently. Since ETFs trade like a stock, you buy and sell shares on an exchange at a price determined by supply and demand. That's why an ETF's market price can differ from its net asset value (the value of all securities inside minus liabilities, divided by the total number of shares outstanding).

ETFs have all of the benefits of index funds with some additional benefits. The fees for ETFs are often, but not always, cheaper than index funds, and they may cost less in taxes than index funds.

Costs: Many good ETFs have very low fees, compared with traditional mutual funds. While some mutual funds require a $2,000 minimum investment, ETFs can be used as an alternative. To reduce the cost of an ETF, individuals can purchase them through an online brokerage that charges low commissions.

Taxes: ETFs are big winners at tax time. As with any index fund, the manager of the ETF doesn't need to constantly buy and sell stocks unless a component of the underlying index that the ETF is attempting to track has changed. (This can happen if companies have merged, gone out of business or if their stocks have moved dramatically). And given the special way ETFs are structured, they're often more tax-efficient than traditional index mutual funds. However, some ETFs are mimicking newer, less-static indexes that trade more often. These funds may trigger more capital gains costs. Trading in and out of ETF shares can generate taxable gains, just like stocks.
Diversification: Like index funds, ETFs provide an efficient way to invest in a specific part of the stock or bond market (ie: small-cap stocks, energy or emerging markets), or the entire Standard & Poor's 500.

Open Book: Again, since they track an index, you usually know exactly what's inside an ETF. With traditional mutual funds, holdings are usually revealed with a long delay and only periodically throughout the year (mutual funds that track a specific index are the exception here).

User-Friendliness: ETFs can be bought or sold at any time during the day, just like stocks. Mutual funds, on the other hand, are priced only once at the end of each trading day.

Since ETFs trade like stocks, buyers must pay a brokerage commission every time they buy or sell shares. Those commissions add up quickly, especially if more shares are purchased each month. ETFs are great for lump-sum investors, but a traditional index fund should be used for multiple purchases.