Exchange-traded funds (ETFs) are relatively new investment instrument. Mutual funds are considered one of the oldest investments in financial markets. Nevertheless, both funds are good choices for investors. But before including either of these funds in your investment portfolio, the article will outline its similarities and differences.

Structure of Exchange-Traded Funds (ETFs)

  • Exchange-Traded Grantor Trust - This fund is similar to a closed-end fund. But unlike ETFs and closed-end mutual funds, an investor has the ownership interest on the underlying company stocks in which the fund is invested in, as well as the voting rights. Although dividends are not reinvested in the fund, these are directly paid to shareholders. Investors must trade in 100-share lots.

  • Exchange-Traded Unit Investment Trust (UIT) - Such funds do not automatically reinvest dividends, but pay cash dividends quarterly. Regulated by the Investment Company Act of 1940, this fund must mimic their given indexes, limit investments in an issue to 25% or lower, and place additional weighting limitations for diversified and non-diversified funds.

  • Exchange-Traded Open-End Index Mutual Fund - The dividends are reinvested on the day of receipt and given to shareholders quarterly. Such funds allow securities lending and using derivatives. This type of fund is enlisted under the above-mentioned legislation.

Structure of Mutual Funds

  • Open-Ended Funds - These are the prevailing funds in mutual fund markets based on its volume and assets under management. Purchasing and selling fund shares are done directly between investors and the fund company. There is no limit on the number of shares such funds can issue. Regulations require daily valuation process known as marking to market, which adjusts the fund’s per-share price in order to show changes in the asset’s (or portfolio’s) value. The number of shares outstanding do not affect its value.

  • Closed-End Funds - Regardless of the investor demand grows, such funds only issue a limited number of shares and do not give new shares. But the prices are determined by investor demand, not the fund’s net asset value (NAV). Shares are often bought at a premium or discount.

Speaking of trading, ETFs have greater flexibility than mutual funds since buying and selling directly occur between investors and the fund company. The fund’s price is not set until the business day ends, when the Net Asset Value (NAV) is determined. Conversely, institutional investors made or redeem the ETFs in huge lots, and shares are being traded throughout the day like a stock. ETFs can be sold short, which is favorable to short-term investors. But since markets continuously price ETFs, these can only be traded using the true NAV, reflecting a potential opportunity for arbitrage.

ETFs are less expensive than many mutual funds. Those with lowest expense ratios charge around 0.10% while the highest ones charge about 1.25%. The lowest fund charges range from 0.01% to over 10% annually for other funds. Another consideration is the product acquisition costs, if any. Mutual funds are frequently obtained at NAV or divested of any loads, but many funds have commissions and loads, some are as high as 8.5%. But ETF purchases are free of broker loads.

To those considering ETFs and/or mutual funds, they also look at additional transaction fees. But its pricing largely varies on the account size, the purchase size, and pricing schedule of every brokerage company. Oftentimes, clients pay as low as $9.95 for each ETF purchase or $20 for mutual funds. Investors should also consider additional expenses if they plan to employ dollar-cost averaging to buy into the mutual funds or ETFs since trading the latter can escalate commissions and offset the benefits from lower charges.

Mutual funds are dependent on the day-to-day trade volume, expressed as the number of shares traded daily. Securities with low trading volumes are illiquid, hence greater spreads, causing the buyer to pay at a premium and the seller into a discount to sell the securities. ETFs are immuned to this since it accounts the liquidity of the stocks included in the index.

Now which is better: ETFs or mutual funds? Both are viable investment instruments. Choosing the fund to be included in your investment portfolio will depend on one’s financial goals and objectives.