7 Reasons Why an ETF Beats a Mutual Fund

The ETF, or Exchange Traded Fund, has been available to investors since 1993 (1999 in Europe) and is, in essence, an index fund that can be traded like a stock. There are at least 300 available ETFs on various stock markets, including the NYSE and NASDAQ. The mutual fund is also a type of index fund and is available via various investment firms such as Vanguard, Fidelity, and Barclays Global. So, just why does an ETF beat a mutual fund?

The key to understanding the advantages inherent in owning an ETF over a mutual fund lies in each fund's origins. An ETF is typically created when an investment firm, such as Barclays, allocates baskets of stocks, commodities, and bonds from funds that are already in existence, such as pension funds. These stock baskets, which can sometimes be as large as 200,000 shares, are exchanged for creation units. An authorized participant, who usually works for the firm, divides up the creation units into a set amount of shares, and these shares are submitted for approval by the SEC and then listed on an exchange as an ETF. The ETF's assets are already owned by individual investors, with these investors simply loaning out their equities for a small interest rate.

In contrast, the mutual fund is created by investors sending their money to an investment firm. Once sufficient capital is accumulated, the firm's money managers meet and decide exactly which stocks will be purchased with that cash. After all stocks have been purchased and a pre-determined amount of cash collected, the mutual fund is usually closed to future investors. Investors are typically expected to maintain their holdings in a mutual fund for a specified amount of time, and early withdrawal is usually penalized by high exit fees.

As a result of these inherent differences between ETFs and mutual funds, ETFs have the following 7 advantages over mutual funds, namely:

Liquidity: An ETF is bought and sold like a stock, and can even be shorted or purchased on margin. Mutual funds have a complex buying and cashing out structure, with penalty fees assessed for early withdrawal.

Easy entry: Mutual funds typically require several thousand, or even tens of thousands of dollars for initial investment. An ETF can be bought in single shares or even one share. Most ETF share prices run $100 or less, with some ETFs costing about $20/share.

Low fees: Mutual funds often have load, maintenance, exchange, redemption, account, and redemption fees associated with them. There are also the 12b-1 fees, which pay for distribution (e.g., advertising) and investor services. ETFs pay a small interest fee to the investors who have loaned their stocks to create the ETFs. There is also a nominal annual fee paid to the fund manager. The authorized participant, meanwhile, makes most of his or her money by taking advantage of the bid-ask spread of the ETF, as well as the price difference between the stocks that make up the ETF and the ETF itself.

Simple taxation: If an investor sells his or her shares of a particular ETF, those sold assets return to the original investors who loaned them out. If a large amount of a mutual fund is sold and cannot be covered by the firm's assets, the money manager must sell a significant portion of the fund's portfolio in order to make the payout. This can lead to capital gains taxation and other issues with the IRS.

Benchmark performance: Funds typically compare their performances to some type of benchmark, such as the performance of the S&P 500. Because ETFs are based on equities that are already in existence and whose performance is known, they often outperform their benchmarks. Mutual funds, whose equities must be discovered and picked up by money managers, frequently underperform their benchmarks.

Knowledge: An ETF is built on a planned amount of stocks and other equities that the investment firm already owns. Future equity purchases or trades can be predicted with ease, since in most cases the firm owns or will own those equities. Mutual funds, meanwhile, are based on the stock and equity purchases of money managers who perform their duties as money enters or leaves the mutual fund. In many cases, the money managers do not know which stocks will be purchased until a given amount of capital has been raised.

No trading incentive: Money managers of mutual funds are often rewarded with equity trade commissions, giving them an incentive to do frequent stock trades even if such trading inevitably hurts the mutual fund. The authorized participant of an ETF may or may not generate additional creation units from the firm's equity holdings, since there is no monetary incentive to do so.