Exchange-traded funds and mutual funds are both vehicles designed to make it easier to invest. Both will bundle different securities together, providing lower risk through instant diversification.
Both types of funds can be either actively or passively managed (though ETFs tend to have passive strategies), and both will take most of the work off your hands, as they have managers to monitor the funds' individual holdings and adjust them as necessary.
Although ETFs and mutual funds share many qualities, it's important to understand their significant differences.
ETFs are constantly traded and priced throughout the day, just like individual shares of companies, while mutual funds trade only at the end of each day. A mutual fund will calculate the price of its outstanding shares using the fund's net asset value, which is the total net assets of the fund divided by the number of shares outstanding. Meanwhile, ETFs are priced based on supply and demand -- again, just like individual equities. One of the big benefits to this is that you can buy or sell on the spot, know the exact price you paid or received, and not have to wait until the end of the day to have your order executed.
While both ETFs and mutual funds have expenses, the expense ratios of ETFs are often substantially lower than those of mutual funds. For example, the annual expense ratio of the Vanguard S&P 500 Index ETF is 0.05% as compared with Dreyfus S&P 500 Index Fund at 0.50% -- a full 10 times higher. Some ETFs incur a sales commission (as do some mutual funds) when being bought or sold, but the larger discount brokers, such as TD Ameritrade and Charles Schwab, offer many ETFs commission-free.
My two very favorite things about ETFs that aren't true of mutual funds are that you can trade options on ETFs and that ETFs aren't required to spit out their capital gains at the end of the year, as regulated investment companies are. The laws governing regulated investment companies require them to distribute 90% of their capital gains resulting from trading; ETFs do not have this requirement. If you've ever been hit with a huge capital-gains tax liability on a mutual fund that you didn't even sell, then you'll understand the beauty of this ETF feature.
The ability to trade options allows you to hedge and generate some income by writing covered calls on your ETFs. And the substantial tax advantage of ETFs owes to their structural nature. Mutual fund investors will make share exchanges directly with the fund, while ETF investors will make this exchange with a middleman called an authorized participant. In addition to being a middleman between the capital markets (the underlying shares) and the ETF custodian (the ETF company), this authorized participant is responsible for providing investors with the actual ETF shares in exchange for cash. The exchange between the authorized participant and investors is labeled as in-kind, which reduces long-term capital-gains tax and increases tax efficiency for the ETF investor.
The best choice for you
As you may have guess by now, I believe ETFs are the superior investment. Granted, there are certain situations in which a mutual fund may better fit the bill. Due to the fact that ETFs have not been around all that long, there are some investment strategies that can only be accomplished via a mutual fund. However, given their greater liquidity, lower expenses, and similar (or even superior) returns, ETFs are preferable to their mutual fund counterparts in nearly every instance.
Helen Simon has no position in any stocks mentioned. The Motley Fool owns shares of and recommends TD Ameritrade. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.