Exchange Traded Funds and Mutual Funds: Two Investment Vehicles – How to decide?

First, let’s start with the basic definition of an Exchange Traded Fund (ETF). “An Exchange Traded Fund is a marketable security that tracks an index, a commodity, bonds, or a basket of assets like an index fund, ” according to Investopedia.com.

Second, let’s look at the basic definition of a mutual fund. “A mutual fund is a company that pools money from many investors and invests the money in securities such as stocks, bonds, and short-term debt,” according to Investor.gov.

A comparison of ETF’s and mutual funds.

ETF’s and mutual funds share more similarities than differences. Both investment vehicles offer diversification. By pooling money together from many investors, ETF’s and mutual funds have greater buying power, enabling them to buy many different securities in large quantities. They gather money from many investors and use it to acquire stocks, bonds, and other assets. Another similarity is transparency. Compared with actively managed funds, most index ETF’s and index mutual funds are extremely transparent. Also, in the United States, all mutual funds, as well as the vast majority of ETF’s, are subject to strict regulation under the Investment Company Act of 1940 and associated Securities and Exchange Commission rules and regulations.

“The tax efficiency of an investment product generally has more to do with how it is managed—index versus active—than whether the product is structured as an ETF or mutual fund,” according to Vanguard.com.

This brings our discussion to that of the differences between ETF’s and mutual funds. The first major difference between ETF’s and mutual funds is trading flexibility. Unlike mutual funds, an ETF trades like common stocks on a stock exchange. This means that ETF’s experience price changes throughout the day as they are bought and sold. On the other hand, an order to buy or sell a mutual fund is executed at the end-of-day price, known as the net asset value. This means that mutual funds experience price changes only at the end of the trading day.

Next, the most prevalent difference between ETF’s and mutual funds is the way costs are charged to the investor. While ETF’s and mutual funds share some common costs, ETF’s have unique costs not associated with mutual funds. The main difference is the Bid and Ask spread. “While trading ETF’s on the secondary market, there is a difference between the price a dealer is willing to pay for the ETF (the “bid”) and the somewhat higher price the dealer will accept to sell the ETF (the “ask”), ” according to advisors.vanguard.com.

“The amount by which the ask price exceeds the bid price is called the “bid-ask spread.” An ETF usually trades as closely to its net asset values, or NAV, as possible. The market provides a lot of liquidity to the system in order to ensure this. However, for some low-volume ETFs, bid-ask spreads may exist and widen. Trading ETFs with large spreads may decrease potential returns since they affect the ETF purchase and sales prices. Investors may also purchase an ETF above its NAV, which essentially means paying a premium for the basket of securities,” according to a recent article on finance.yahoo.com.

In the end, ETF’s and mutual funds may be suitable alternatives to stocks and bonds. Investors need to consider all of the similarities and differences between the two in order to make an informed decision.