Costs
ETFs trade on an exchange. Each transaction is subject to a brokerage commission. Commissions depend on broker, with various "plans" and different conditions, so no simple rule can be given. A "typical" schedule (at least in the United States) is $10 or $20, increasing slowly, or not at all, for larger orders. What is clear, however, due to the quasi-flat charge, amount invested has a great bearing; someone who wishes to invest $100 per month may have 10% of their money vaporized immediately (which is ludicrous), while for someone making a $200K investment, commission may be, essentially, negligible. Generally, mutual funds obtained directly from the fund company itself do not charge a brokerage fee. Where low or no-cost transactions are available, ETFs become very competitive.
Most ETFs have a lower expense ratio than comparable mutual funds. Not only does an ETF have lower shareholder-related expenses but, because it does not have to invest cash contributions or fund cash redemptions, an ETF does not have to maintain a cash reserve for redemptions and saves on brokerage expenses.Mutual funds can charge 1% to 3%, or more; index funds are generally lower, while ETFs are almost always in the 0.1% to 1% range. Over the long term, these cost differences can compound into a noticeable difference.
ETFs are almost always compared to no-load funds, for the simple reason that, compared to loaded funds, there is no comparison. A person investing $100K in a load fund may have $5K disappear immediately, which is much higher than any conceivable brokerage commission.
Mutual funds may also charge for too short a holding period, which is nonexistent with ETFs. In fact, ETFs can be bought and sold in the same day, although it's not obvious that it's a good idea. This has made ETFs subject of some criticism, since low fees may cause investors to trade more quickly. In this view, traditional mutual funds are doing investors a favor by charging fees such as front loads.
Taxation
ETFs are structured for tax efficiency and can be more attractive than mutual funds. In the U.S., whenever a mutual fund realizes a capital gain that is not balanced by a realized loss, the mutual fund must distribute the capital gains to its shareholders. This can happen whenever the mutual fund sells portfolio securities, whether to reallocate its investments or to fund shareholder redemptions. These gains are taxable to all shareholders, even those who reinvest the gains distributions in more shares of the fund. In contrast, ETFs are not redeemed by holders (instead, holders simply sell their ETF shares on the stock market, as they would a stock, or effect a non-taxable redemption of a creation unit for portfolio securities), so that investors generally only realize capital gains when they sell their own shares or when the ETF trades to reflect changes in the underlying index.In most cases, ETFs are more tax-efficient than conventional mutual funds in the same asset classes or categories.In the U.K., ETFs can be shielded from capital gains tax by placing them in an Individual Savings Account or self-invested personal pension, in the same manner as many other shares
Trading
Perhaps the most important benefit of an ETF is the stock-like features offered. Since ETFs trade on the market, investors can carry out the same types of trades that they can with a stock. For instance, investors can sell short, use a limit order, use a stop-loss order, buy on margin, and invest as much or as little money as they wish (there is no minimum investment requirement). Also, many ETFs have the capability for options (puts and calls) to be written against them. Mutual funds do not offer those features.
For example, an investor in a mutual fund can only purchase or sell at the end of the day at the mutual fund's closing price. This makes stop-loss orders much less useful for mutual funds, and not all brokers even allow them. An ETF is continually priced throughout the day and therefore is not subject to this disadvantage, allowing the user to react to adverse or beneficial market condition on an intraday basis. This stock-like liquidity allows an investor to trade the ETF for cash throughout regular trading hours, and often after-hours on ECNs. ETF liquidity varies according to trading volume and liquidity of the underlying securities, but very liquid ETFs such as SPDRs can be traded pre-market and after-hours with reasonably tight spreads. These characteristics can be important for investors concerned with liquidity risk.
Another advantage is that ETFs, like closed-end funds, are immune from the market timing problems that have plagued open-end mutual funds. In these timing attacks, investors trade in and out of a mutual fund quickly, exploiting minor variances in price in order to profit at the expense of the long-term shareholders. With an ETF (or closed-end fund) such an operation is not possible—the underlying assets of the fund are not affected by its trading on the market.
Investors can profit from the difference in the share values of the underlying assets of the ETF and the trading price of the ETF's shares. ETF shares will trade at a premium to net asset value when demand is high and at a discount to net asset value when demand is low. In effect, the ETF is providing a system for arbitraging value in the market. As the initial costs are one-off, the ETF vehicle offers some cost advantages over other forms of pooled investment vehicles.
Criticism
John C. Bogle, founder of The Vanguard Group, a leading issuer of index funds (and, since Bogle's retirement, of ETFs), has argued that ETFs represent short-term speculation, that their trading expenses decrease returns to investors, and that most ETFs provide insufficient diversification. He concedes that a broadly diversified ETF that is held over time can be a good investment
ETFs are dependent on the efficacy of the arbitrage mechanism in order for their share price to track net asset value. While the average deviation between the daily closing price and the daily NAV of ETFs that track domestic indexes is generally less than 2%, the deviations may be more significant for ETFs that track certain foreign indexes
ETFs offer little or no advantage over index funds for tax-deferred, long-term, retirement investors, because such investors typically conduct little if any trading and tax issues are of little concern for them
In a survey of investment professionals, the most frequently-cited disadvantage of ETFs was the unknown, untested indexes used by many ETFs, followed by the overwhelming number of choices
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