Exchange-Traded Funds (ETFs) combine features of mutual funds and stocks. While ETFs share some features with mutual funds, some key structural differences can affect an investor’s investment exposure and tax consequences.
Index ETFs and Index Mutual Funds
Index mutual funds and most ETFs are managed passively. Index funds aim to mirror the fund’s performance to a specific underlying market index before fees and expenses. The fund’s index benchmark is a standard against which a fund’s performance is usually measured.
Active Mutual Funds
Active mutual funds seek to outperform market indexes. Fund managers use their own judgement and experience when it comes to making investment decisions. Mutual funds must provide a fund objective and a map to an investment style or investment strategy, though the managers of active funds generally have more latitude in choosing investments than index fund managers do.
A difference between ETFs and mutual funds is usually in the way the fund itself is traded. Mutual funds are bought and sold directly from the mutual fund company at the current day’s closing price, and the Net Asset Value (NAV) is calculated for the fund at the end of the day.
Typically, ETFs are traded throughout the day at the current market price, similar to a stock, and are likely to cost more or less than NAV.
At the same time, mutual fund transactions do not include commissions to a brokerage, while some ETF transactions do.
Similarly, another key difference between ETFs and mutual funds (active and index) is that investors buy and sell ETF shares with other investors on a stock exchange.
As a result, the ETF manager doesn’t have to sell holdings – potentially triggering capital gains – to meet investor redemptions. Mutual fund shareholders tend to redeem shares directly from the fund. The fund manager must sell fund securities to honour redemptions, potentially triggering capital gains that affect all of the shareholders in the fund.
Transparency is access to information about which stocks and/or bonds a fund holds—the batch of companies that you access when an investor buys a fund share.
- ETFs: Generally disclose holdings daily
- Mutual Funds: Generally disclose holdings
Knowing exactly what you are investing in is important information an investor needs to make financial decisions. An important piece of advice would be that one can minimise risk by buying shares of a mutual fund or an ETF that is pegged to several companies under a market index, industry sector or market capitalisation (m-cap).
Rajiv is an independent editorial consultant for the last decade. Prior to this, he worked as a full-time journalist associated with various prominent print media houses. In his spare time, he loves to paint on canvas.