Created in the 1990s, ETFs combine the best features of traditional mutual funds and equity securities. Like mutual funds, ETFs are diversified mixes of stocks, bonds or other assets that seek to reduce individual security risk through diversification. Like equities, ETF shares are traded during the day on a national stock exchange at market prices.
ETFs are low-cost. Because most ETFs are passively managed and designed to track the performance of a specific index, they are low-cost. Not only is the average ETF net expense ratio generally significantly lower than that of actively-managed mutual funds. Two Wharton studies found that the trading costs for a sample of equity mutual funds averaged 0.78% of fund assets per year in addition to the mutual funds’ published expense ratio costs.
ETFs are tax-efficient. Like mutual funds, ETFs must distribute income and realized capital gains annually. However, unlike mutual funds, ETFs generally distribute modest, if any, capital gains. This is due to low turnover and an in-kind redemption process available to ETFs but not to mutual funds.
ETFs are transparent. In addition to the quarterly disclosure required for all mutual funds, ETFs publicly disclose their securities holdings every day. ETFs are subject to federal securities laws and regulations designed to protect investors from various risks, and are subject to oversight by a fund Board of Directors.
See, Chalmers, Edelen and Kadlec, “Mutual Fund Trading Costs,” (November 2, 1999) and “Transaction-cost Expenditures and the Relative Performance of Mutual Funds,” (November 23, 1999), The Wharton School, University of Pennsylvania.