Exchange-traded funds, or ETFs, are similar to mutual funds because both instruments bundle together securities to offer investors diversified portfolios. Typically anywhere from 100 to 3,000 different securities can make up a fund. Yet, the two investment types are marked by significant differences.
The Differences
ETFs trade throughout the trading day, like stocks, while mutual funds trade only at the end of the day at the net asset value (NAV) price. Most ETFs track a particular index and as a result have lower operating expenses than actively-invested mutual funds. Thus, ETFs may improve your rate of return on investments. In addition, ETFs have no investment minimums or sales loads, unlike traditional mutual funds, which often have both. Most indexed mutual funds, however, will not have sales loads.
Taxes and Rate of Return
ETFs create and redeem shares with in-kind transactions that are not considered sales. Thus, taxable events are not triggered. Redemptions create tax events in mutual funds, but they do not create tax events in ETFs. When a forced sale of stock occurs, mutual funds record and distribute higher levels of capital gains than ETFs.
In addition, ETFs have greater tax efficiency due to a structure that allows them to substantially decrease or avoid capital gains distributions altogether. This difference can greatly affect the overall rate of return, even if an ETF and mutual fund both track the identical index.
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