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This chapter has described the ways in which ETFs possess characteristics of both traditional open-end mutual funds and shares in individual companies. Like mutual funds, ETF shares represent a proportional ownership in a portfolio of individual stocks or bonds. All the ETFs currently listed have investment transparency—you know exactly what you are buying. Although it is usually not important for an individual mutual fund investor to know precisely what stocks are in his fund's portfolio, in the past, some mutual funds deviated from their original objectives, leading investors to assume risks of which they were unaware when they selected the fund.

Like individual stocks and in contrast to open-end mutual funds, ETFs trade on exchanges. This means that your transaction costs are likely to be greater with an ETF than with a no-load mutual fund purchased directly from the fund company. For long-term shareholders, their transaction costs might ultimately be offset by an improvement in ETF performance compared to a comparable mutual fund because ETF shareholders do not bear transaction costs arising from buy and sell orders from other shareholders.

Another difference between ETFs and mutual funds is that ETF share prices are subject to shifts in the balance between supply and demand at the time you place your order. This represents an additional risk that is nonexistent with open-end funds.

The flexibility of ETFs has led a wide range of investors to utilize them. We have, however, just barely begun to discuss the advantages of ETFs. Specifically, we have referred to potentially greater tax efficiency compared to regular mutual funds and to the benefits to long-term shareholders of not having their long-term performance eroded if other shareholders effect large or frequent transactions.

The next two chapters teach you how to evaluate mutual fund and ETF performance and show you in which areas ETFs have outperformed a majority of their actively managed competition.

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