ETFs offer some advantages over mutual funds

August 1, 2007

Exchange-traded funds (ETFs) are investment portfolios that trade like stocks on an exchange.

Key Points

Q: How does an ETF differ from a typical mutual fund?

To understand the major differences between open-end mutual funds and ETFs, it's important to understand how their structures differ. In a typical open-end mutual fund, investors buy shares in the fund directly from the mutual fund, whether the purchase is made directly with the fund or bought through a brokerage account. The money is then put to work according to the fund's investment goals spelled out in its prospectus. When the investor is ready to sell his shares, the mutual fund company will redeem the shares for the investor. Of course, if many shareholders decide to sell shares on the same day, the mutual fund may have to sell off some of its portfolio holdings to repay the selling shareholders.

As with all investments, there are a number of advantages and disadvantages to consider and evaluate prior to making an investment. On the plus side, ETFs as a whole have generally lower operating costs. By not having to deal with a large number of individual investors, expenses can be less, thus providing lower overall expense ratios. The low turnover, buy-and-hold approach of many of the ETFs may lead to a higher degree of tax efficiency. The taxation to the investor is generally limited to the gain or loss associated with the sale of the ETF, as opposed to capital gains or losses within open-end mutual fund shares. Trading flexibility is certainly one of the main advantages for active traders. Because ETFs trade like stocks, investors can use the same trading tools used for individual stock trading, such as stop loss orders, selling short, or even buying shares on margin, by using borrowed money.

In terms of disadvantages, a few main issues must be considered. The first is commission charges. Unlike no-load open-end mutual funds that typically have no sales charge or costs associated with buying shares, an ETF trade will incur a commission charge for each transaction made, regardless of whether it's buying initial or additional shares or selling any of the held shares. Many investors like the ability to use client services that many open-end mutual funds offer, such as dividend reinvestment programs and cost basis tracking, which are typically not available with ETFs. Additionally, most ETFs are focused on duplicating a specific index return, while many open-end mutual funds, in addition to indexing, may also rely on portfolio managers who attempt to outperform those indices.

Keep in mind that costs, while an important factor, should not be the only consideration in making investment decisions. ETFs, mutual funds, stocks, bonds, and other investment vehicles are simply tools that can be used to construct an efficient investment portfolio based on your own specific goals and objectives. The advice and assistance of your financial adviser certainly can be helpful as you compare the many different investment options that are available in today's financial marketplace.

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