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ETF Performance Is Not Weighed Down by Transaction Costs

As mentioned earlier, all mutual fund shareholders bear the costs incurred as a result of purchases or redemptions by every other shareholder. Such costs are typically modest for any transaction that an individual investor might request. However, if large numbers of shareholders request redemptions or make purchases at the same time, the fund might incur significant costs.

Many funds restrict the number of transactions that each investor can make in a given year to avoid these types of costs. However, the larger problem for mutual fund investors is what would happen if a large number of long-term shareholders decided to run for the exits at the same time. That could happen on a day of a significant market decline, such as occurred on October 19, 1987, when the S&P 500 Index lost more than 20 percent of its value during just that one day.

ETFs do not suffer from this risk because the only way for ETF shares to be redeemed is with a transfer of shares of individual stocks. No cost is involved in simply transferring stocks from one account to another, so the performance for remaining ETF shareholders is not adversely affected when ETF shares are redeemed. Those costs fall entirely on the authorized participant firms if they elect to liquidate shares they have received from a creation or redemption.

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