As the popularity of exchange-traded funds (ETFs) continues to grow, particularly as compared to the historical use of mutual funds (properly known as "open-end investment companies"), the question arises as to why this is occurring. To properly answer this question, let’s look at the comparative advantages of ETFs as compared to mutual funds.
First, a greater investor understanding of the importance of costs or fees in achieving an absolute rate of return has taken place over the last several years. While academic studies with respect to average costs vary, most show the average cost of an actively managed, equity mutual fund to be approximately 1.1 percent (or, as we say, in the investment world, "110 basis points") (Note a "basis point is equal to one/one hundredth of a percent). Compare this to the average cost of an equity ETF of .25 percent, or less than one quarter as much, and you can begin to see why ETFs have grown in popularity. Specifically, ETFs are managed "passively", meaning that they do not try and outperform the market or market "index" (such as the Standard & Poor’s 500 index of stocks) on a long-term basis and, therefore, do not incur trading costs nearly as frequently as "actively managed" mutual funds.
Second, ETFs trade differently than mutual funds. An ETF "trades like a stock", meaning an immediate price is obtained when there is a trade of the share (or more properly, the "depository receipt"). Like a mutual fund, whereas technically an ETF trades at the fund’s "net asset value" (or "NAV") determined at the end of the trading day, the more relevant value for an ETF trade is its "intraday NAV", the difference between the ETF’s NAV and its market price. Sometimes, the market price can be significantly different than the NAV for the ETF, as has been experienced quite recently in the "thousand points a day" market drops resulting from fear of the Coronavirus on the nation’s economy. Accordingly, the advantage of trading at an immediate price can be easily understood!
A third major difference between the mutual funds and ETFs is in the types of investments that each fund purchases. There are numerous categories of mutual funds depending on the fund’s investment objective, but, generally, the funds invest in only individual stocks or bonds, or in a combination thereof, known as a "balanced fund". Alternatively, in keeping with its "passive management" approach, an ETF invests primarily or solely in a "basket" of stocks or bonds, referred to as an "index" in the market. The ETF then trades that "basket" infrequently, reducing its trading costs, and attempts only to replicate the performance of the index (not outperform the index). Usually, the ETF is very successful in its goal of "replication", although sometimes the actual return achieved by an investor will vary slightly from that of the index due to the ETF’s "tracking error" (a concept which will not be gotten into here).
Finally, ETFs have income tax advantages as compared to mutual funds. Whenever an investor owns a mutual fund, and the fund declares a capital gain distribution (usually annually), the investor must report this distribution on his or her income tax return and pay "capital gains taxes" on the amount. Since the mutual fund manager usually trades frequently (or "turns over" the portfolio’s holdings), every time the assets of the fund are sold for a profit, the investor pays taxes. Alternatively, "capital gains taxes" are not paid by the ETF owner until the entire ETF is sold rather than its individual holdings. Moreover, an ETF sometimes distributes the ETF position in stock rather than cash, meaning that investor payment of taxes can be delayed to a later time when the investor sells the stock position itself. Good tax management always involves retaining the choice of when to pay taxes in the hands of the investor/taxpayer and not leaving this decision to the fund manager!