Traded Funds (ETFs)
Lower fees: When compared with actively managed funds, ETFs have much lower expense ratios. Each week, Zack's e-newsletter will address topics such as retirement, savings, loans, mortgages, tax and investment strategies, and more. An index fund buys all or a representative sample of the bonds or stocks in the index that it tracks.
It owns assets (bonds, stocks, gold bars, etc.) and divides ownership of itself into shares that are held by shareholders. Mutual funds are subject to market, exchange rate, political, credit, interest rate, and prepayment risks, which vary depending on the type of mutual fund.
General Illiquidity: While exchange-trading sounds great, not all ETFs are as tradable as you think. The stop price triggers the order; then the limit price lets you dictate exactly how high is too high (when buying shares) or how low is too low (when selling shares).
ETFs can entail risks similar to direct stock ownership, including market, sector, or industry risks. ETFs may involve trading commissions, but some brokerages offer commission-free ETFs. The short-term trading fee may be more than applicable standard commissions on purchases and sells of ETFs that are not commission-free.
With an ETF, you may only owe taxes on any capital gains when you sell the security. If you're like many investors saving for retirement or another goal, you've heard about portfolio diversification. On the other hand, ETFs offer more trading flexibility, provide more transparency, and are more tax efficient than mutual funds.
Others look at taxes, reserving the ultra-tax-efficient ETFs for taxable accounts and using mutual funds in tax-deferred accounts. Once you're set there, feel free to dedicate 5% or 10% of your portfolio to stock trading for a little thrill. Investing in ETFs means taking on that duty or outsourcing it to a financial advisor or robo-advisor.
Any trades placed during the day will all be priced at the NAV determined at the close of the trading day. Like individual stocks, ETFs are listed on the major stock exchanges. Jokes aside, it is an ambitious and time-consuming undertaking to build a portfolio out of individual stocks.
That said, according to Morningstar, the average ETF expense ratio in 2016 was 0.23%, compared with the average expense ratio of 0.73% for index mutual funds and 1.45% for actively managed mutual funds. ETFs are more tax efficient than mutual funds because of the way they are created and redeemed.
Although there are some commission-free ETFs in the market, they might have higher expense ratios to recover expenses lost from being fee-free. There are fewer taxable events because while mutual funds often must sell securities when shares are redeemed, ETFs are simply traded between investors and no underlying assets must be sold just because shares of the ETF are sold.
However, if you have an ETF vs. mutual fund dilemma, consider the disadvantages of mutual funds, and then consider the advantages ETFs bring to the table. More specifically, the market price represents the most recent price someone paid exchange traded options for that ETF. The tax advantages of ETFs are of no relevance for investors using tax-deferred accounts (or indeed, investors who are tax-exempt in the first place).