Are ETFs a better choice than Mutual Funds?

Legal structure of Mutual Funds

Mutual Funds are generally of two types:

Open Ended Funds: These account for majority among mutual funds in terms of no and type of assets being managed. Here all transactions involve only the client i.e. the investor and the fund company. No of shares depends on the investors demand. There is no cap on the amount of shares being issued. They can easily be issued and redeemed at any stage of the scheme unlike close ended funds.

Close Ended Funds: They are limited in number and new ones are not issued. You can only purchase them from an existing investor through the stock exchange. Here prices are fuelled exclusively by investor demand.

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Legal Structure of ETFs

Exchange-Traded Open-End Index Mutual Fund: Here the profit generated is put back into the fund and is cumulatively paid to the investor every quarter

Exchange-Traded Unit Investment Trust: They have to be registered under the Investment Company Act of 1940. Here the trust sells the shares to interested investors and over a pre determined period keeps pushing the profits towards the shareholder. They differ from Mutual Funds as their securities are not managed actively.

Exchange-Traded Grantor Trust: They are similar to ETFs but with the exchange-traded grantor trust the owner is considered as a shareholder and has full voting rights while also receiving all the dividends. Granter ETFs like Unit Investment trusts give the dividend directly to the shareholder without any reinvestment. Also they have no portfolio management charges.

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Trading Methodology of ETFs vs Mutual Funds

Exchange Traded Funds like stocks can be bought and put on sale at any time during the trading day. They however keep a hold on a basket of stocks in a specific industry. They are more flexible than mutual funds while trading. The Net Asset Value is determined at the end of a trading day. They also like stocks can be sold short which make them interesting to traders but not for long term investment.  Mutual funds reveal their value of holdings on a quarterly or semiannual time period whereas ETFs put their values public daily.

Exchange Traded Funds Expenses

Expense ratios of Exchange Traded Funds in comparison with Mutual Funds are considerably lower and sometimes even lower than index mutual funds. Due to the low portfolio turnover the may have much lowers costs of trading than funds that are actively handled, hence more cost saving for those looking for long term investments. They do have brokerage commission costs but the money saved from lower expense ratio help cover these costs sufficiently.

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Advantages and Disadvantages of Taxes levied

Both mutual funds and ETFs push forward their profits and dividends to their share holders annually. These can be caused due to rebalancing of indices or various other factors. Selling of these funds can also cause taxes to be levied. In the US ETFs which are held in taxable accounts along with long term capital profits are taxed at 15%, whereas the ones with short term benefits are taxed normal federal tax rates. Taxes are not limited to selling these ETFs but can/will be incurred even if you hold on to them. Their Low portfolio turnovers however insure less taxation. Also the share holders are not affected by the activities of other shareholders as in comparison to mutual fund holders untimely sales do not lead to them fielding the tax gains and losses through their own accounts.

Liquidity of ETFs

Etfs are considered more liquid than mutual funds because they can achieve the same broad diversity as indexed mutual funds while also having the freedom to buy and sell them during trading hours. The liquidity of ETFs is governed by its composition and the volume of the individual securities trading.

Cons of ETFs

Great care has to be taken regarding the company in which you are investing as there are chances of it going bust. The life and the market health of the company are a must know before investing in it. This will lead to an unwelcome liquidation pushing towards you unwarranted taxation charges.

In today’s market environment you are being exposed to a variety of options. It is however of the outmost importance that you make an informed decision keeping your requirements in mind.

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