Exactly what is the difference between exchange traded funds and traditional mutual funds? Everyone knows about mutual funds and how they work, yet a newer, more tax efficient solution may be around the corner. Exchange traded funds trade on an exchange like stocks so that you buy shares from an investor that already owns them. When there aren’t enough investors to buy shares from shareholders, or, shareholders willing to sell shares to the uninitiated, the brokerage firm or institutional investor buys a basket of securities that mirrors the investments of the exchange traded funds. In other words, the securities work as collateral for the risk, in which case that risk is sold as cash for the investors. The mutual fund actually sells the securities, where as the exchange traded funds merely exchanges the securities, thus the name exchange traded funds.
Like mutual funds exchange traded funds track an index, and the value can fluctuate when stocks that aren’t as valuable as they used to be are sold in lieu of more favorable ones. Then you’re stuck with taxable capital gain distributions. A capital gain is what happens when “the amount by which proceeds from the sale of a capital asset exceed the original cost” in which case you are essentially taxed for the over performance of the exchange traded fund.
The exchange traded fund is good for the long term investor, because they tend to perform better than mutual funds. Your primary exception would be if you invest smaller amounts (in mutual funds) because your brokerage costs are lower. Exchange traded funds were popular back in the days of the tech bubble because these indexes contained some of the highest performing stocks in the market. They can be traded as easily as stocks, in comparison to mutual funds that are priced at the end of the day.
Ask yourself the following questions before you dive head-first into exchange traded funds.
- Are you a day trader comfortable with buying and selling a fund that is essentially an index or snapshot of the stock market at that particular time?
- If you are that trader, can you afford the costs of buying and selling throughout the day?
- If you are not, are you confident that the conservative approach of the mutual fund is one that will help you achieve your financial goals over time, or are you looking for something “in-between” (slow performance) mutual funds and (volatile) stocks and bonds?
- Can you afford to buy on margin in hopes of staying ahead of the curve through borrowing shares?
- Finally, are the brokerage costs worth paying for this approach to trading?
Exchange traded funds are an interesting option for those already seasoned in trading stocks, yet an expensive choice for those just starting in the stock market. Figure out what your investing goals are first before pursuing this new approach to trading.