EXCHANGED TRADED FUND (ETF) VS. MUTUAL FUND

All funds are a collection of individual securities which are bought and sold as the fund attempts to meet its investment objectives.

Management philosophies fall into one of two camps, often called “active” and “passive”. Active funds (most mutual funds) seek to outperform market indexes. Fund managers study the market and draw on their investment experience and expertise to try to maximize the fund’s performance. Mutual funds are required to provide investors with a fund objective and a map to an investment style, though the managers generally have some freedom to choose the investments they think will perform best.

“Passive” funds, by contrast, seek to match the fund’s performance to an established market index, such as the S&P 500 or FTSE 100. A passive fund’s performance is measured by how well it replicates its chosen index. Index funds and most ETFs fall into this category.

One difference between ETFs and mutual funds is in the way the funds themselves are traded, which has a few implications for investors.

Mutual funds are bought and sold directly from the mutual fund company at the current day’s closing price, the NAV (Net Asset Value). ETFs are traded throughout the day at the current market price, like a stock, and may cost slightly more or less than NAV.

Mutual fund transactions do not include commissions to a brokerage, while some ETF transactions do. (Check with your brokerage for their specific pricing structures).

In all funds, there are two types of fees to watch: transaction fees and the fees included in the fund’s expense ratio.

For mutual funds, transaction fees may include sales loads (or sales charges) or redemption fees. These are paid directly by investors. ETF transactions may include brokerage commissions (just as stock trades do), which are paid directly by investors.

The expense ratio represents the operating costs of a fund divided by the average dollar value under management as of the fund’s fiscal year end. The expense ratio is calculated annually and reported in the fund’s prospectus. The largest and most variable part of these costs is usually the fee paid to the fund managers — the "management fee".

Other aspects of these operating costs can include custodial services, recordkeeping, legal expenses, acquired fund fees and expenses (if the fund invests in other funds), accounting and auditing fees, or a marketing fee (called a 12b-1 fee). Operating expenses are taken out of the fund itself and therefore lower the return to the investors. In general, funds that pursue an active investment strategy will have higher operating costs than passive funds.

Since fees vary so much across funds, investors should take time to understand all the fees associated with a fund they might purchase.

ETFs are typically structured with the aim to shield investors from capital gains taxes. Currently, nearly all ETFs are index funds — so, like index mutual funds, they typically trade less frequently than most actively managed funds and so generally create fewer taxable capital gains for fund-holders.

What’s the relationship between fund turnover and taxable capital gains? One key difference between ETFs and mutual funds (whether active or index) is that investors buy and sell ETF shares with other investors on an exchange. As a result, the ETF manager doesn't have to sell holdings — potentially creating capital gains — to meet investor redemptions. Mutual fund shareholders redeem shares directly from the fund. The fund manager must often sell fund securities to honor redemptions, potentially triggering capital gains which then trickle down to the fund’s investors.

Certain traditional mutual funds can be tax efficient and, of course, ETF shareholders can incur tax consequences when they sell shares on the exchange, but that tax consequence is not passed on to other ETF shareholders.

Transparency is access to information about which stocks and/or bonds a fund holds—the batch of companies that you’re buying when you buy a fund share.

• ETFs: Generally disclose holdings daily.
• Mutual Funds: Generally disclose holdings quarterly.

Because of their longer disclosure cycle and the greater leeway that active fund managers have when choosing investments, some mutual funds have historically been affected by style drift, where the fund’s holdings can change over time and sometimes stray farther than the fund’s intended strategy than investors may realize. Knowing exactly what you are investing in is important information you need to make financial decisions.