Compare ETFs to Other Products

It's important for investors to understand the key differences between exchange-traded funds (ETFs) and their two closest relatives: stocks and mutual funds. Each has its advantages and disadvantages.

Stocks

Diversification

Diversification is an attractive feature of ETFs. Instead of taking concentrated risks by purchasing individual stocks, investors can own an index of stocks with ETFs. Owning individual stocks has special risks and often requires diligent attention.

In addition to reducing market volatility, many investors have cut their commitment to time-consuming and expensive individual stock research and focused on broader sectors. By over and underweighting ETF industry sectors, for example, investors can obtain an optimal allocation that suits their financial goals.

Leverage

Like individual stocks, ETFs can be leveraged with margin. Margin is borrowing money from a broker to buy securities and involves considerable risk. Minimum maintenance requirements are enforced by the FINRA (Financial Industry Regulatory Authority) and by individual brokerage firms. While margin investing can be profitable for investors who are correct about the direction of their holdings, the interest charges or borrowing costs can deteriorate returns.

Shorting

ETFs, like individual stocks, can be shorted. Shorting involves selling borrowed shares an investor does not own in expectation the price of an ETF will decline in value. If the ETF does decrease in value, it can be bought by the short seller at a lower price, which results in a profit. Shorting is an advanced technique and involves substantial risk.

Capital Gains Distributions

Capital gains distributions can also be paid out of an ETF annually even if you do not sell the fund.While ETFs typically have very low turnover, changes in the underlying index or basket of stocks can cause the fund to sell a holding and realize a capital gain. This is passed on to the investor in the form of a taxable capital gain distribution at the end of the year. With individual stocks, you would only realize the capital gain or loss at the time shares are sold.

Mutual Funds

Fees

The expense ratios of ETFs are generally lower than actively managed mutual funds. In some cases, this includes even index mutual funds. Also, ETFs often have lower trading costs versus actively managed funds due to their low portfolio turnover. The ETF cost savings can be significant, especially for long-term investors. Investing in ETFs will usually result in a brokerage commission, but the savings from lower expense ratios can help to offset these transaction costs. Information on specific fees, charges and expenses is obtained in the fund prospectus.

Fund Transparency and NAV

Actively managed mutual funds report their holdings on a quarterly or semiannual basis, whereas exchange-traded funds disclose their portfolio holdings on a daily basis. This provides ETF investors with a greater degree of financial transparency. The ETF performance and portfolio composition are a reflection of the underlying index or basket of securities. Consulting the index provider's Web site is another method for easily identifying the underlying holdings of an index ETF.

Mutual funds are bought and sold at net asset value (NAV), which is determined by subtracting a fund's liabilities divided by the number of shares outstanding from the value of a fund's total assets. All buy and sell transactions are conducted directly with the fund company. In contrast, ETFs are bought and sold on an exchange based upon market prices, which fluctuate continuously throughout the day according to supply and demand. This allows ETF investors to capture intraday price movements and use order types such as market, limit and stop orders.

ETFs generally trade close to their net asset value. It's rare to see ETFs trading at a large premium or discount to their NAV, but it can happen. Historically, institutions have seen this as an arbitrage opportunity by creating or liquidating creation units. This process keeps ETF share prices closely hinged to the NAV of the underlying index or basket of securities.

Taxes and Portfolio Turnover

Annually, both mutual funds and ETFs are required to distribute dividends and portfolio gains to shareholders. This is usually done at the end of each year, and these distributions can be caused by index rebalancing, diversification rules or other factors. Also, anytime you sell your fund this could generate tax consequences.

 

Stocks

ETFs

Mutual Funds

Continuous trading and pricing throughout the day

Yes

Yes

No

Can be bought on margin

Yes

Yes

Yes

Can buy/sell options

Yes

Yes

No

Can be actively traded

Yes

Yes

No

Tax Efficient

Yes

Yes

Sometimes

Expense ratio

N/A

Typically Lower

Typically Higher

Investors should consider the investment objectives, risks, charges, and expenses of a mutual fund or Exchange-Traded Fund (ETF) carefully before investing.A prospectus contains this and other information. A mutual fund prospectus is available through www.scottrade.com or through a Scottrade branch office. An ETF prospectus can be obtained directly from the issuer. The prospectus should be read carefully before investing.

Options involve risk and are not suitable for all investors. Detailed information on our policies and the risks associated with options can be found in Scottrade's Options Application and Agreement, Brokerage Account Agreement, and Characteristics and Risks of Standardized Options (available at your local Scottrade branch office or from the Options Clearing Corporation at 1-888-OPTIONS or by visiting www.888options.com). All option accounts require prior approval by Scottrade. Market volatility, volume, and system availability may impact account access and trade execution. Supporting documentation for any claims will be supplied upon request.

Margin trading involves interest charges and risks, including the potential to lose more than deposited or the need to deposit additional collateral in a falling market. Scottrade's margin agreement, available at scottrade.com or through a Scottrade branch office, contains the Margin Disclosure Statement and information on our lending policies, interest charges and the risks associated with margin accounts.

Diversification does not assure a profit, or protect against loss, in a down market.