Exchange-Traded Funds allow investors to trade index portfolios just as they do shares of stock. Exchange-Traded Funds can be sold throughout the day, unlike open-ended mutual funds which can be traded only at the end of the day when net asset value is calculated. Moreover, the Exchange Traded Funds can be sold short or purchased on margin.
Exchange-Traded Funds also offer potential tax advantage over mutual funds. The capital gains tax that results when the fund sells securities to meet the redemptions made by investors are passed through to the remaining investors of the mutual fund. In the case of Exchange Traded Funds, investors sell their shares to other investors. Therefore the fund need not sell securities. Hence there will be no capital gains tax incurred by the fund.
Large investors can redeem Exchange Traded Funds for a portfolio of stocks comprising the index or exchange a portfolio of stocks for shares in the corresponding Exchange Traded Funds. This ensures that the price of an Exchange Traded fund will be close to the net asset value of that portfolio. Any significant discrepancy would offer arbitrage opportunities for these large traders, which would quickly eliminate the disparity.
Exchange-Traded Funds are also cheaper than mutual funds. Investors who buy Exchange Traded Funds do so through brokers rather than buying directly from the fund. Therefore, the fund saves the cost of marketing itself directly to small investors. This reduction in expenses results in lower management fees.
There are some disadvantages to Exchange Traded Funds, however.
- Because they trade as securities, there is the possibility that their prices can depart by small amounts from net asset value. As noted, this discrepancy cannot be too large without giving rise to arbitrage opportunities for large traders, but even minor differences can easily swamp the cost advantage of Exchange Traded Funds over mutual funds.
- While mutual funds can be bought at no expense from no-load funds, Exchange Traded Funds must be purchased from brokers for a fee.