Open-End Index Mutual Funds Vs. ETFs

Note: This article is only comparing open-end Indexed funds with ETFs, since most people purchase open-end funds rather than close-end index funds. While there are similarities and differences between these two products and closed-end funds, adding that investment to the discussion would make it too confusing.

Similarities

ETFs are exchange-traded funds and contain of investments from a specified index, just like indexed mutual funds that also mirror a specified index. . The investments may be stocks, commodities, foreign indices or bonds. If the index they track drops an investment or adds a new one, both have to make changes to the funds.

History

Indexed mutual funds arrived on the market late in 1975. It was the First Index Investment. Even though many called it foolish, it became popular and later became Vanguard 500 Index Fund. Almost 14 years later, ETFs followed indexed funds with an unsuccessful attempt because of a lawsuit in 1989. In 1993, AMEX created the successful Standard & Poor's Depositary Receipts ETF.
Sale and Redemption

Open-ended indexed mutual funds redeem customer shares and create new ones as required. You purchase the shares for the POP, public offering price and sell them back to the company at the NAV, net asset value or the value of the underlying investments at the close of the market day. The company always purchases your shares. No matter what time of day you purchase or sell the indexed mutual fund, the company determines the price after the market closes.

ETFs sell on the open market rather than through the investment company. If you purchase the shares at 10 a.m., you buy it for the price at that moment, just as you do when you buy and sell stocks. Sometimes, that price bears no resemblance to the value of the underlying investments but depends on the price people are willing to pay for the shares. You are at the mercy of the market when you sell your shares. If no one wants to buy them, you're stuck. However, that normally doesn't happen.

Cash Drag

The managers of indexed funds have to kee4p money on hand to redeem shares. This means they can't invest it. This "cash drag" often makes the indexed mutual funds have a lower return in rising markets. ETF shares trade on the open market and there's no need for cash to redeem shares.

Dividends

Indexed mutual funds reinvest dividends with no fee to purchase more shares of the fund if the shareholder requests it. ETFs hold the dividends until the end of the quarter and then distribute them. In a rising market, this costs the ETF holder the potential gain and brokerage fees to purchase additional shares.

Tax Efficiency

Large investors redeem cause a capital gain if they sell their indexed fund shares. The fund must sell the underlying stock to pay the investors. The law requires the fund to pass the triggered capital gain to pass through to all the investors holding the fund shares. The larger investors of ETF holdings can trade their shares on the open market or exchange the shares for the underlying investment vehicles to avoid taxation by making a "like and kind" sale, which is not a taxable event. No other shareholders feel the effect of the sale due to taxation, but it might drive the share price down.

Timing

When you buy or sell mutual funds, the price used is the closing price. ETF purchases and sales occur as soon as there are two parties willing to make the transaction, just like stocks, so you can take advantage of bumps in the market price.

Trading

If you exchange an indexed mutual fund for another indexed mutual fund, there's no additional fee or load to pay. When you exchange an ETF using the open market, you have the brokerage expense on both trades. While indexed funds often have a load, there is also a difference between the bid and asked price for ETFs.

Exchange for Other Funds

If you want to follow a different index, you can trade your indexed fund for any other fund in that family of funds without incurring another sales charge. There are brokerage charges at both ends, the purchase and sale, for ETFs.

Personal Preference

There is no right or wrong choice when you select between indexed funds and ETFs. If you like the excitement of the stock market, you'll love ETFs. However, in order to diversify your investments across many indices, you need more than one fund. It isn't logical for smaller investors to pay the brokerage fees for a small number of shares in each ETF, but mutual funds allow you to invest a minimal amount every month. You can frequently invest as low as $25 per fund, giving more people the opportunity to diversify.

Resources:

Personal experience as a stockbroker.

Princeton University Library, Mudd Manuscript Library: John C. Bogle Papers
http://diglib.princeton.edu/ead/getEad?eadid=MC206&kw=

EFT Trends: How to Trade Large Blocks of ETFs Efficiently
http://www.etftrends.com/2010/01/how-to-trade-large-blocks-of-etfs-efficiently.html

Investopedia.Com: ETFs Vs Index Funds: Quantifying The Differences
http://www.investopedia.com/articles/mutualfund/05/ETFIndexFund.asp

Nasdaq: What Are ETFs?
http://www.nasdaq.com/investing/etfs/what-are-ETFs.aspx

The Street Directory: The ABCs of Exchange Traded Funds.
http://www.streetdirectory.com/travel_guide/141684/trading/the_abcs_of_exchange_traded_funds.html

Altruist Financial Advisors, LLC: ETFs vs. Indexed Mutual Funds
http://www.altruistfa.com/etfs.htm