Exchange-traded funds (ETFs) combine the diversification of mutual funds with the liquidity of individual investments, which is one reason they have attracted investors in recent years. ETF assets have more than tripled since 2007, reaching $1.8 trillion by mid-2014. Still, that figure falls far behind the $13.1 trillion of assets invested in mutual funds.1
Both ETFs and mutual funds are portfolios of securities assembled by an investment company. Their underlying investments are typically selected to track a particular market index, asset class, or sector — or they may follow a specific strategy. You might invest in both types of funds to create a broad core portfolio or to target narrower market segments.
Because mutual funds and ETFs can hold dozens or even hundreds of securities, they could provide greater diversification at a lower cost than you might obtain by investing in individual stocks and bonds. Diversification does not guarantee a profit or protect against investment loss; it is a method used to help manage investment risk.
In spite of their similarities, you should be aware of some key differences between these two types of pooled investments.
Trading. Typically, mutual fund shares are purchased from and sold back to the investment company, and the price is determined by the net asset value at the end of the trading day. By contrast, ETFs can be bought and sold throughout the trading day like individual stocks. The price at which an ETF trades on an exchange is generally a close approximation to the market value of the underlying securities, but supply and demand may cause ETF shares to trade at a premium or a discount.
Costs. Although ETFs often have lower expense ratios than similar mutual funds, you must pay a brokerage commission whenever you buy or sell shares of an ETF. Thus, mutual fund shares may be less expensive to purchase on a regular basis than ETF shares, but they might be more expensive to own over a long period of time.
Taxes. Because of their structure, ETFs tend to be relatively tax efficient. Only a small percentage of ETFs distribute capital gains, so you would not incur capital gain taxes unless you sell shares for a profit. For this reason, high-income investors may favor ETFs over mutual funds for assets held in taxable accounts. (Some ETFs may occasionally distribute capital gains if there is a shift in the composition of the underlying assets.)
Accessibility. Because a brokerage account is needed to purchase shares, ETFs are not widely available to investors who make regular contributions to employer-sponsored retirement plans. Outside of a workplace plan, mutual funds may require a minimum investment (typically $1,000 to $3,000); this is not the case with ETFs.
Exchange-traded funds have matured into sophisticated tools that may serve specific portfolio needs, but they are not appropriate for everyone. The ability to buy or sell shares quickly during market hours could encourage you to trade more often than needed or to make emotional trading decisions during bouts of market volatility.
The principal value of ETFs, mutual funds, and stocks will fluctuate with changes in market conditions. Shares, when sold, may be worth more or less than their original cost.
Exchange-traded funds and mutual funds are sold by prospectus. Please consider the investment objectives, risks, charges, and expenses carefully before investing. The prospectus, which contains this and other information about the investment company, can be obtained from your financial professional. Be sure to read the prospectus carefully before deciding whether to invest.
1) Investment Company Institute, 2014
The information in this article is not intended as tax or legal advice, and it may not be relied on for the purpose of avoiding any federal tax penalties. You are encouraged to seek tax or legal advice from an independent professional advisor. The content is derived from sources believed to be accurate. Neither the information presented nor any opinion expressed constitutes a solicitation for the purchase or sale of any security. This material was written and prepared by Emerald. Copyright 2015 Emerald Connect, LLC.