"How ETFs are Different than Mutual Funds"
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Exchange traded funds vs mutual funds.
Mutual funds are pools of money by thousands of shareholders that is invested in more things than the shareholders could afford to buy individually. When you send in money to an open-ended mutual fund (the most common and well-known type), the fund uses it to buy stocks, bonds or other securities. Each share of the mutual fund which you own is worth whatever the net value of the investments happen to be at the end of that day.
This has been a traditionally popular way for individual investors to diversify their investments. Any one stock or bond can go down, but by opening up an account with a mutual fund, you can obtain a share in hundreds of stocks and bonds. You could never diversify that much on your own.
Most Mutual Funds are Actively Managed
That is, the head of the fund uses your money to buy or sell securities based on their evaluation of its value. If they guess right most of the time, the value of your mutual funds shares go down.
The exact figures vary, but over the long term only a tiny number of mutual fund managers outperform the market. Therefore, John Bogle of the Vanguard Group created the Vanguard S and P 500 index mutual fund, which simply tracks the S and P 500 index.
Exchange Traded Funds are like mutual funds in the sense that they represent your ownership interest in a large number of pooled securities. However, the two are different.
Mutual funds, even index ones, must continually buy and sell securities as investors open up accounts, deposit money, withdraw money and close their accounts. Therefore, even index funds must maintain a certain level of cash to send to investors who withdraw money.
Shares of open-end mutual funds are created and dissolved every day
Mutual Funds Are More Expensive Than Exchange Traded Funds
That's because investors making deposits are buying their shares from the mutual fund itself. When they withdraw money, their shares are dissolved.
ETFs start out with a fixed number of a basket of securities (usually replicating an index), but they don't buy or sell them unless they must, to track the index. The number of shares of the exchange traded funds are fixed, and are themselves like shares of stock that are bought and sold on the secondary market. The ETF fund itself has nothing to do with the trading. They no more buy and sell shares of stock than General Motors sells off an assembly line to pay you for selling its stock.
This has a benefit to you. Exchange traded fund expenses are a lot less, because they don't manage so much paperwork or pay transaction fees. Even the Vanguard mutual fund family -- famous for its dedication to keeping mutual fund expenses to a minimum -- cannot match the cost savings of ETFs. Many mutual fund investors don't think about expenses, but there are costs associated with running a mutual fund, and they're paid by the account holders, which lowers their investment performance.
Also, if a mutual fund becomes so popular (say it's featured in a magazine article or book), it can be so flooded with cash from new investors that the fund manager may have to lower their standards about what to buy, lowering their previous performance
This becomes a problem with very successful funds such as Fidelity's Magellan Fund. Its very success becomes a problem, as the manager struggles to find worthwhile securities to buy with the cash at their disposal. Many times such funds close themselves to new investors.
The opposite problem can occur with mutual funds doing badly. Their account holders may decide to run for the doors at once, forcing the manager to sell even the best-performing securities, dragging the price or net asset value (NAV) down even further.
Closed end mutual funds are like ETFs in some ways
They issue a set number of shares at the beginning, and those shares are then bought and sold on the secondary market (that is, through brokers). However, a closed-end mutual fund can be actively managed. That is, the fund manager can buy and sell shares within the rules of the fund (most specialize in some way). Also, dividends and capital gains are reinvested in new securities.
Open-ended mutual funds are easy to make deposits to, and you can reinvest your dividends and capital gains. However, the price of a mutual fund's shares for any transaction is determined by its NAV at the close of the day's trading. This is not normally a big deal, but if there's a panic such as the October 1987 drop or even the recent Red Tuesday when the market fell 416, you can call your mutual fund at 10:00 AM in the morning, but the shares they sell will still be priced at the close of market price, which could be much lower than the 10:00 AM price.
Legally, mutual funds are exempt from paying taxes -- but you aren't
With Exchange Traded Funds You Pay Capital Gains Taxes Only When You Choose to Sell Them
That means that when the fund manager sells a stock for a profit, you're going to have to pay the capital gains tax on your proportionate share of the transaction by April 15 of the next fiscal year. This is a major drawback to mutual funds that many people don't understand.
What can be particularly frustrating is that you can owe taxes on your mutual funds even if their prices go down. The fund manager may sell stock for a profit in June, making you liable for the capital gains tax. But they keep stock that goes way down in value. Your overall account balance is low, but Uncle Sam still wants his share of the "gain" you had from the June sale.
Since exchange traded mutual funds are more like shares of stock themselves, you incur capital gains taxes on them if and when you sell them for a profit. It's your decision. You have greater control. Some ETFs do incur capital gains taxes when they must sell securities no longer in a given index, so I can't say they're tax-free, but it's much less of a problem than open-end mutual funds are.
Also, if your ETF pays a dividend (and you shouldn't own any other type, in my opinion), the money is sent to you.
Also, many mutual funds charge "loads" -- on the front or back end. These are charges to get in or out of the fund. Studies have shown that no-load funds perform better than load funds, but many people still pay the loads. With ETFs, you pay only a broker's commission just as you do to pay shares of stock.
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