Comparing Exchange Traded Funds To Mutual Funds
A Head-To-Head Comparison Reveals Why ETF's Are Superior Investment Vehicles And Will Ultimately Silence The Critics

Exchange Traded Funds differ from mutual funds in several respects. It is important to understand these differences when comparing the two as investment vehicles. The most prominent distinguishing feature is that Exchange Traded Funds are bought and sold on an exchange, while mutual funds shares are acquired and redeemed directly with the fund manager.

This core difference results in a rippling effect, creating a number of advantages, and perhaps disadvantages, for ETF's in comparison to traditional mutual funds. Because they are traded on an exchange, Exchange Traded Fund prices change throughout the day comparable to individual stocks, while mutual fund prices are calculated, based on their Net Asset Value, or NAV, at the end of each day. In essence, mutual funds recalcuate their NAV based on the closing values of the stocks, and other assets, held by the fund. After calculating the new NAV, the fund will issue shares to buyers and redeam shares from sellers.

Because ETF shares are traded during the day on a stock exchange, you may execute your buy and sell orders at any time during market hours. You may also make use of your broker's advanced order types. This means that you can use stop orders, limited orders, contingent orders, and any other advanced order types offered by your brokerage firm. These orders are very effective for protectng capital against significant loss and ensuring that purchases are only made at favorable price levels.

An Exchange Traded Fund's holdings are transparent. In other words, the particular assets contained within the ETF are always known to the market. Managed mutual funds are not required to disclose exactly what securities they currently hold. This can make the art of diversifying a portfolio a bit more challenging for the mutual fund investor.

There are costs associated with both Exchange Traded Funds and mutual funds. Generally, ETFs have lower annual fees than comparable index-based mutual funds, and significantly lower fees than actively managed mutual funds. Also, ETFs do not have investment minimums, except to the extent that an investor cannot buy a fractional share in an ETF, or special sales charges (‘loads’) imposed by some mutual funds. However, you will need to pay a brokerage commission each time you buy or sell ETF shares.

Another advantage is that Exchange Traded Funds are typically more tax efficient than mutual funds. Capital gains taxes are payable on ETFs based solely on when you buy and sell your shares. Taxes on mutual funds, are not only incurred on gains at the time you sell, but you will also owe taxes based on periodic capital gains distributions the fund makes to you. Of course, this tax issue is not of concern if your investments are maintained as part of a tax deferred or tax free investment account such as an IRA, Roth IRA, or a 401k plan.

For sophisticated investors, another enormous benefit offered by many Exchange Traded Funds is the availability of a liquid options chain. This means that an investor who understands how to use options, can implement strategies to enhance investment performance and protect capital against loss. Options can also be used to gain leverage, produce income, and reduce market risks. Options simply are not available on mutual funds.

There are critics of Exchange Traded Funds. However, a close look at the criticisms being levels raises suspicions that the ney sayers are most likely advocating mutual fund investing in an effort to maintain the status quo and their source of income.

Critics contend that there are too many Exchange Traded Funds, with many being duplicative of what is already available in the market, making it hard for investors to choose. There are for more mutual funds than ETF's, which makes this a curious criticism. In fat, if too much choice is a negative, then we must assume that mutual funds lose this round to the smaller Exchange Traded Fund industry.

As more specialized Exchange Traded Funds have come to market, critics have argued that they are too narrowly focused resulting in more volatile and risky funds. The volatility and associate risk is a function of the specific market sector addressed by the ETF. The mutual fund industry also has its specialty funds, which are no less prone to risk. At best, this criticism results in a tie between the two products.

The ability to trade ETFs during the day has caused some to argue that these products promote speculative, short-term practices. It is true that the ease of trading ETFs does make them conducive to short-term trading or chasing the latest hot sector. This assumes that short-term trading is something to be avoided, when, in fact, the large institutions routinely engage in this practice. A skilled short-term trader can generate significantly better returns than the traditional "buy and hold" investor, a fact proven year-after-year by large investment banks and brokerage firms that routinely return significant profits from their in-house traders. This argument is a paternalistic statement that assumes individual investors are too ignorant to be trusted with powerful investment tools, while all that is really required is a sound education.

Lastly, the final argument espoused centers upon commissions. The argument is that commissions can add up If you buy and sell alot of small lots of ETF shares. It is true that each time you execute a buy or sell transaction, you will incur a commission expense. However, commission expenses have been significantly reduced through discount brokerages and is an cost controlled in large part by the investor who elects when these transactions will take place. Mutual funds impose their own fee structure, which must be fully offset against any commission expenses before this argument can be given any merit. A sophisticated investor can also take steps to mitigate their commission expenses through improved investment returns or appropriately tailored option strategies.

In the final analysis, most investors will find that Exchange Traded Funds are an excellent substitute for mutual funds within their portfolio. Those investors who take the time and make the investment in a sound and ongoing financial education will also find that ETF's continue meeting their needs through the many benefits they afford while mutual funds will need to be replaced within the portfolio before they can pursue more advanced investment strategies. It makes considerable sense to incorporate Exchange Traded Funds into your portfolio now, as you will be better prepared for tomorrow's investment challenges.

by TheOptionClub.com -

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