Who: This post is for people who want to know the differences between ETFs (exchange traded funds) and mutual funds.
What: This post compares and contrasts exchange-traded funds and mutual funds as investment vehicles. ETFs vs mutual funds, here we go…



Expense Ratios

In general, exchange traded funds have lower expense ratios than mutual funds. A large percentage of exchange traded funds passively track an index without significant manager intervention. This passive management contrasts the active management style of many mutual funds where more investment manager decisionmaking takes place. This added “expertise” tends to cause mutual funds to have higher expense ratios than ETF’s. It is important to note that there are plenty of mutual funds that also passively replicate indices and these funds tend to have lower expense ratios than their actively managed counterparts.

Mechanical Differences

Exchange traded funds behave just like regular stocks in terms of purchases and sales. In order to purchase an exchange traded fund, you can place an order for the shares on the market and your order is filled just like it would be for any other stock traded on an exchange. You will incur regular brokerage fees for purchasing or selling exchange traded funds.

Tax Considerations

Generally, ETFs are more tax-efficient than their mutual fund counterparts. The first reason is due to turnover. When securities are bought and sold, capital gains or losses are realized and these are passed on to investors. The more turnover their is in the securities of a fund or ETF, the more capital gains taxes there will be. Typically, ETFs have lower turnover ratios than mutual funds because of the difference between active and passive management (discussed in “Expense Ratio” area). However, it is important to note that some ETFs have high turnover rates and some mutual funds do have low turnover ratios so it is important to check your specific choices.

According to current tax law, qualified dividends are taxed preferentially. In order to qualify for preferential treatment of the dividends, a stock must have been held for at least 60 days and since ETF’s do not always fulfill this requirement, a portion of dividend payouts may indeed be taxed regularly and not in the tax-efficient manner that qualified dividends are taxed.

Cost Differences

Both mutual funds and ETFs have expense ratios. Mutual funds have brokerage commissions based on the brokerage you are using. Typically, these fees will be much higher than regular stock purchases unless the mutual fund is a no transaction fee mutual fund. ETFs do not have a special brokerage commission charged but they do incur the cost of a regular trade made at a brokerage. This fees will be paid when you purchase shares as well as when you sell them.

Additionally, ETF’s include an embedded cost of the spread. When you are purchasing a security, there is a price at which the market is offering the shares and there is a price as which the market is offering to buy shares. The difference between the two prices is called the bid/ask spread. Whenever you purchase an ETF, you are paying half the bid/ask spread up front when you make the purchase. For heavily traded ETFs this spread may only be a few cents but for thinly traded ETFs this spread may be far larger.

Cash Drag

Mutual funds are typically required to maintain cash on hand in order to immediately handle redemptions. This constant carrying of cash causes a slight bias of the mutual fund’s return (whether positive or negative) towards the cash rate. Since ETFs do not have to deal with “redemptions,” ETFs do not have a “cash drag.”

So, which do I choose?

A Financial Revolution does not take an outright position on which instrument is better. Ultimately, based on the information given and the specific ETFs and mutual funds themselves, you should be able to make an educated assessment about which investment vehicle is best for you…

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