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I've been considering, but haven't committed myself yet to investing in Exchange Traded Funds (ETFs), but have to admit that I don't yet fully understand the use-case for them.

What factors are relevant in making the decision between investing in mutual funds versus ETFs? For example, in terms of liquidity, tax treatment, expenses, risk, etc?

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The main difference between an ETF and a mutual fund is liquidity and sometimes taxes. ETFs and mutual funds can track a specific index with NO manager input, or be actively managed.

Liquidity ETFs trade like a stock, so you can buy at 10am and sell at 11am if you wish. Mutual funds NAV (NAV = Net Asset Value) is calculated at the end of each business day, so there is no intraday trading. Also, ETFs are similar to stocks in that you need a market buyer/seller whereas a mutual fund's units are sold back to itself. Mutual Funds can be closed to trading, however it is rare.

Tax treatment Both come down to the underlying holdings in the fund or ETF. However, more often in Mutual Funds you could be stuck paying someone else's taxes, not true with an ETF. For example, you buy an Equity Mutual Fund 5 years ago, you sell the fund yourself today for little to no gain. I buy the fund a month ago and the fund manager sells a bunch of the stocks they bought for it 10 years ago for a hefty gain. I have a tax liability, you do not even though it is possible that neither of us have any gains in our pocket. It can even go one step further and 6 months from now I could be down money on paper and still have a tax liability.

Expenses A Mutual Fund has an MER or Management Expense Ratio, you pay it no matter what. If the fund has a positive return of 12.5% in any given year and it has an MER of 2.5%, then you are up 10%. However if the fund loses 7.5% with the same MER, you are down 10%. An ETF usually, but not always, has a smaller management fee (typically 0.10-0.95%) but you will have trading costs associated with any trades. Risks involved in these as well as any investment are many and likely too long to go into here. However in general, if you have a Canadian Stock ETF it will have similar risks to a Canadian Equity Mutual Fund. I hope this helps.

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    not all ETFs simply track an index, commodity, currency, etc. Recently there has been an emergence of actively traded ETFs: seekingalpha.com/article/…. – zpesk Aug 5 '10 at 23:11
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    Conversely, some mutual funds do track a specific index. Also, ETFs will in general have lower fees but they don't always have lower fees. It is worth checking. – rhaskett Mar 9 '15 at 19:56
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    @farnsy That's wrong. At least in US, and I believe other countries too, a mutual fund must distribute (essentially all) its net earnings as dividends; the schedule can vary some, but quarterly is common. They (almost always) have an option to automatically reinvest dividends on your behalf, but for tax purposes you received the dividends and then invested them, and you must report the dividends as taxable -- unless they are exempt for another reason, e.g. the fund holds municipal bonds. – dave_thompson_085 Jun 17 '16 at 17:04
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    How does this answer survive marked as the answer? This is wrong. All ETFs are mutual funds but not all mutual funds are ETFs. All index mutual funds are mutual funds but not all mutual funds are index mutual funds. I believe there are Index mutual funds that trade as ETFs as well. The part about tracking an index needs to be removed. ETFs trade like stocks, but instead of shares of a company, you're buying shares of a security. – Xalorous Sep 30 '16 at 13:14
  • @Patrick Nicol great answer! Very helpful. In this: It can even go one step further and 6 months from now I could be down money on paper and still have a tax liability. Is this tax liability still that first liability you took on when you joined the MF after they sold those stocks for a hefty gain? Or do you take on a separate liability from something else? – jed Jan 22 at 15:26
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Behind the scenes, mutual funds and ETFs are very similar. Both can vary widely in purpose and policies, which is why understanding the prospectus before investing is so important.

Since both mutual funds and ETFs cover a wide range of choices, any discussion of management, assets, or expenses when discussing the differences between the two is inaccurate. Mutual funds and ETFs can both be either managed or index-based, high expense or low expense, stock or commodity backed.

Method of investing

When you invest in a mutual fund, you typically set up an account with the mutual fund company and send your money directly to them. There is often a minimum initial investment required to open your mutual fund account. Mutual funds sometimes, but not always, have a load, which is a fee that you pay either when you put money in or take money out.

An ETF is a mutual fund that is traded like a stock. To invest, you need a brokerage account that can buy and sell stocks. When you invest, you pay a transaction fee, just as you would if you purchase a stock. There isn't really a minimum investment required as there is with a traditional mutual fund, but you usually need to purchase whole shares of the ETF. There is inherently no load with ETFs.

Tax treatment

Mutual funds and ETFs are usually taxed the same. However, capital gain distributions, which are taxable events that occur while you are holding the investment, are more common with mutual funds than they are with ETFs, due to the way that ETFs are structured. (See Fidelity: ETF versus mutual funds: Tax efficiency for more details.) That having been said, in an index fund, capital gain distributions are rare anyway, due to the low turnover of the fund.

Conclusion

When comparing a mutual fund and ETF with similar objectives and expenses and deciding which to choose, it more often comes down to convenience. If you already have a brokerage account and you are planning on making a one-time investment, an ETF could be more convenient. If, on the other hand, you have more than the minimum initial investment required and you also plan on making additional regular monthly investments, a traditional no-load mutual fund account could be more convenient and less expensive.

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    Good answer; exactly what I was looking for and corrects the errors in the other answer. – keshlam Jun 16 '16 at 17:06

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