Pros and Cons of Investing in Exchange-Traded Funds (ETFs) vs Mutual Funds

The similarities between exchange-traded funds (ETFs) and mutual funds are arguably more important than the distinctions. Both funds are investment vehicles designed to move the investor away from trading individual stocks and other securities, and toward taking advantage of market professionals, in the case of the actively-managed ETFs and mutual funds.

Still, important differences are present in the advantages that ETFs and mutual funds offer the individual investor, and knowing what those differences are will allow you to make the right decision about where to invest. You should talk to an investment advisor or a financial professional, or make sure you do as much research as possible into a particular fund before making a decision about where to put your money.

Advantages of ETFs

The first ETF started in the United States in 1993. These funds turn the logic of the mutual fund around. Mutual funds begin with investors offering their money to buy into the fund, but ETFs start with big institutional investors (known as authorized participants) setting aside big blocks of their shares that track various indexes and allowing individuals to invest in them.

The process is cumbersome, but ETFs are treated just like stocks in almost every way. Instead of investing in a specific company or security, you are investing in a large number of companies or securities that will theoretically track indexes such as the National Association of Securities Dealers Automated Quotations (NASDAQ) or the Dow Jones. ETFs can also be tied to indexes for commodities such as oil and gold and even currencies.

The advantages to ETFs are the same advantages as with stocks:

• You can buy and sell shares at any time during the trading day; whereas mutual fund shares are generally bought or redeemed for their price at the end of the day.
• Similar to handling stocks, investors can also short sell utilizing an ETF, use a limit order, or use a stop-loss order.
• In addition, unlike mutual funds, ETF shares do not have a minimum requirement for how much money must be invested to own them.

ETFs can be more tax efficient than mutual funds. They do not have to respond to capital gains, because the stocks underlying the ETF are not redeemed by the holders. ETFs track indexes and are generally not managed, so administrative fees are usually lower than with a mutual fund. If you invest in an ETF, find out what fees are required and how they will be used.

Disadvantages of ETFs

One major disadvantage of an ETF is a consequence of its advantage. Because it is treated like a stock, investors incur the same brokerage fees as those related to trading regular stock. Therefore, ETFs can be problematic for the investor who wants to continue to put money into the ETF rather than in one lump sum. Unlike ETFs, mutual funds do not charge transaction fees; fees which can end up negating any gain you would receive from the lower administration costs of the ETFs.

Low-cost and no-cost brokerages can help negate this disadvantage, making it more cost-effective to continually invest in an ETF. Using these types of brokerages for ETFs is no different than using them for a regular stock or other investment. If you appreciate the do-it-yourself method of operation, you can take advantage of their lack of fees.

Because ETFs are generally unmanaged, and the managed ones that have been introduced have not yet caught on, investors are generally on their own in terms of expertise and knowledge. When investing in an ETF tracking an index of the stock exchange of a developing country, for example, you will not have a money manager who will determine when to pull your investment out.

Finally, ETFs do not have a mechanism to reinvest the occasional dividend or other cash that can be produced by the underlying securities the way that mutual funds do. You decide what to do with the cash, and if you decide to reinvest, you could be forced to pay a fee.

Overall, mutual funds are probably better for the investor who wants to rely on someone else’s expertise, avoid brokerage fees without using discount brokers, or refrain from reinvesting dividends. If those caveats do not apply to you, then ETFs are certainly a viable investment vehicle.

Additional Resources:

Morningstar, a market analysis site, offers several slide shows dealing with both ETFs and mutual funds.

Vanguard, one of the largest providers of both mutual funds and ETFs in the country, offers a handy way to compare various ETFs and mutual funds offered by the firm.

Fidelity, another large mutual fund and ETF provider, also provides this information.

The post Pros and Cons of Investing in Exchange-Traded Funds (ETFs) vs Mutual Funds appeared first on AllBusiness.com.