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ETFs vs. Index Funds


In the investment world, traditional index mutual funds still dominate but the upstart exchange traded fund industry is slowing gaining ground. When it comes to “beta” indexing investments, ETFs and mutual funds are similar, yet slightly different.

“ETFs and traditional mutual funds are very similar,” Joel Dickson, a senior investment strategist at Vanguard’s investment strategy group, said in a Morningstar article. Both allow investors to access a diversified pool of assets. [Actively Managed Funds Losing Out to ETFs]

“I think the main difference is that with the mutual fund portfolio, you as the investor pretty much interact directly with the portfolio; that is, you buy and sell from the fund,” Dickson said. “With an ETF, generally the interaction is on a brokerage or an exchange, and so it is another person buying and selling shares that occurs in terms of how investors interact.”

Since investors have to go through a brokerage to buy or sell an ETF, there are some indirect cost considerations. [How to Trade ETFs Efficiently]

“You have to take a total-cost mentality in thinking about what the true cost is of the ETF, and that would be not just the ongoing expense ratio of the ETF but also any transaction costs, which would be the commission, bid-ask spread, and so forth,” Dickson said.

Nevertheless, with mutual funds, traders will get their positions executed at around 4:00 at the net asset valued while ETFs, like stocks, can be bought or sold throughout normal trading hours.

Moreover, ETF investors should look at the way the ETF investment vehicles is constructed as it helps lessen tax consequences.

“There are some mechanisms by which ETFs can try to lessen the tax impact in the portfolio, mainly through this process called in-kind redemptions, which is when redemptions occur from an ETF portfolio, they tend to be done in securities rather than cash and that can provide some tax advantages in the portfolio,” Dickson added.

Through in-kind redemptions, ETFs swap securities for other securities and would not cash out positions to incur a taxable event. [Creation and Redemption]

For more information on ETFs, visit our ETF 101 category.

Max Chen contributed to this article.

The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.