How ETFs Work & Why They Differ From Mutual Funds

In a recent blog post, Kiana Danial (a.k.a. The Invest Diva), known for her expertise in -and sole focus on- forex trading, shared some thoughts on other investing opportunities outside the currencies world.

“What's the best, less risky online trading instrument?” she asks. “Since I’m diving into this for the sole reason of portfolio diversification,” she continues, “it only makes sense to go for the industry that allows me to maximize my diversification.”

Although her first instinct was going for Mutual Funds, Danial then discovered “an exciting new alternative that is very similar to mutual funds, only more accessible and retail-trader friendly. Kind of like Mutual Funds 2.0:” ETFs – or Exchange Traded Funds.

ETFs “offer investors a way to pool their money in a fund that makes investments in stocks, bonds, or other assets [of a certain calss] and, in return, to receive an interest in that investment pool,” the investor expounds.

So, she explicates, when investors buy shares of an ETF, what they are buying is “shares of a portfolio that tracks the yield and return of its native index.” However, the Invest Diva notes, ETFs don't seek to outperform their corresponding index; all they do is replicate the index’s performance.

The author then goes into the main differences between ETFs and Mutual Funds:

1)   ETFs are relatively new financial instruments, unlike Mutual Funds.

2)   Mutual Funds are not as tax efficient as ETFs, since the latter “are passively managed portfolios. Therefore they tend to decrease or avoid capital gains comparing to the actively managed mutual funds. ETF’s are traded on an exchange just like a stock, but mutual-funds shares are redeemed with the Fund directly”

3)   ETFs’ trading expenses are lower than Mutual Funds’

4)   ETFs are simpler and more flexible than Mutual Funds

5)   ETFs are certainly more accessible to average investors

6)   ETFs can be traded all day long, like stocks, and unlike Mutual Funds, which can only be traded at the end of each day.