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Monday, January 11, 2010

Comparing ETFs to Mutual Funds

By Jeffrey Jackson

Because ETFs are traded on an exchange, they are subjects to brokerage fees. Mutual funds, on the contrary, when purchased from the original company, are not subject to any brokerage fees. Brokerage fees to purchase ETF shares can range from $11-20 or $3 from online discount brokerages.

When compared to mutual funds, ETFs have much lower expense ratios. Share-holder related expenses are much lower. They also hold an advantage not being required to invest cash contributions, fund cash redemptions nor maintain a cash reserve for redemptions. Their costs hover around 0.1% - 1% in comparison to mutual funds which charge 1% - 3%. As these costs compound they can become very significant in the long run. Mutual funds charge either a front or back end load and when compared to and ETF, which charges no load, an ETF holds a substantial advantage.

In the U.S., ETFs are structured in such a way that they are much more tax efficient than mutual funds. Anytime a mutual fund realizes any sort of gain not offset by a loss, it must distribute a capital gain to its members. Whether it's to fund shareholder redemptions or for the purpose of reallocating investments, anytime a mutual fund sells portfolio securities they must distribute the capital gain to its members. If members decide to invest the gains back into shares of the very same fund they are still legally obligated to pay capital gains tax.

ETFs act conversely. As any other stock they are sold on the stock market, instead of being redeemed by shareholders as is the case with mutual funds. Capital gains are only realized when a share of stock is sold or there is a change in the original index from an index trade. ETFs have grown in popularity because of their tax advantage over mutual funds.

In the U.K., ETFs have even better capital gains benefits. They can be protected from capital gains by placing them in an individual savings account or a self invested pension as they would other shares.

Trading ETFs have some of the great advantages in that they have the ability to perform and function like a traditional share of stock. Short selling, options (puts and calls) can be written against them, buying on margin, stop-loss orders, limit orders all apply as well. None of the previous applies with mutual funds.

Mutual funds, unlike ETFs, only permit their investors to purchase or sell at the end or a trading day at the fund's closing price. This rule removes any benefit to be had from a stop-loss order. Investors are able to trade ETFs during regular trading hours throughout the day because of their stock-like liquidity that comes from its continual pricing throughout the day. - 23212

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