ETFs vs. mutual funds

ETFs might be familiar if you follow the stock market. This category of investment has soared in popularity in recent years. A quick comparison of ETFs and mutual funds can help you understand why ETFs have become so popular. While mutual funds are alive and well, ETFs are like Gen Z — ready with the latest innovations.

ETFs are increasingly popular

Diversification is in the DNA

Like different generations of the same family, ETFs and mutual funds share critical DNA, which is investment diversification. Both ETFs and mutual funds are pooled vehicles that give investors exposure to many securities at the same time. That's an important ingredient for reducing risk.

Why diversification may help investors

  • A stock represents a share in one company, and its price can change for issues related to the company or to its sector, the economy, interest rates, or many other factors.
  • Bad news for a company can come in many forms — a drop in profits, a scandal, a natural disaster, etc. — and some are difficult to see ahead of time.
  • Owning more than one stock can be a strategy for navigating some of these risks because a large group of stocks — 20, 50, or even 500 — does not depend on the performance of one company.

Both ETFs and mutual funds offer diversification by including the stocks of many companies, which is a tool for reducing risk that also saves you the trouble and expense of buying many securities yourself.

ETFs embrace exchanges

ETF is an abbreviation for "exchange-traded fund," and that's the basis for the most important differences from a mutual fund. ETFs own many stocks and trade on exchanges alongside some of the stocks they own. From 9:30 a.m. to 4:00 p.m. Eastern Time, the price of an ETF can change as stock prices change, as well as for other reasons. Investors can buy or sell at the current market prices. Mutual fund buying and selling, in contrast, happens at the end of the day and is based on only the net asset value of the fund, which reflects the closing prices of the underlying stocks held by the fund.

An ETF investor can buy or sell at intraday prices, a flexibility that a mutual fund investor does not have.

ETF vs. mutual fund — pricing practices

ETFs Mutual funds
ETF prices change during market trading from 9:30 a.m. to 4 p.m. ET. Mutual funds are priced once per day when the market closes at 4 p.m. ET.
ETF prices are updated several times per minute as stock prices change. Closing (4 p.m.) prices of stocks are used to calculate the fund's net asset value.
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ETFs may offer tax efficiency

ETFs invest in bundles of securities. The sponsor that issues the ETF assembles these bundles when investors purchase them (or, in the case of certain types of ETFs, called semi-transparent ETFs, the sponsor assembles a bundle that represents the underlying securities). As with buying a stock, there is no tax involved in the purchase. While ETFs are subject to taxes on capital gains and dividend income, they can be more tax-efficient than mutual funds.

Most traditional mutual funds are called open-end funds because they create or redeem shares whenever investors want. In the process, however, the funds might buy or sell securities — buying securities to create shares or selling securities to redeem shares. When a fund sells holdings that have increased in value, it realizes a capital gain. Tax law requires funds to distribute realized capital gains to shareholders each year, making shareholders liable to pay capital gains tax, unless they are invested in the fund through a 401(k) plan or another tax-advantaged structure that allows them to defer taxes. In other words, even shareholders who do not sell their fund shares might still have a capital gains tax liability from the fund. This tax liability, and its timing, is beyond the control of the shareholders in taxable accounts.

Also, capital gains are distributed evenly across each fund share — whether a shareholder has owned the fund for a long time, and participated in the increase in value of the fund, or purchased shares following that increase.

By comparison, ETFs do not redeem shares in the same way. They do not need to sell securities for cash to pay shareholders who redeem the shares, and the process does not typically cause tax liabilities for other shareholders.

ETF vs. mutual fund — capital gains taxes

ETFs Mutual funds
The investor chooses when to sell ETF shares, which is when capital gains liability may occur. Capital gains liability can occur when the fund manager sells portfolio holdings that have embedded capital gains or when the investor sells fund shares.
The process of creating and redeeming shares is less likely to cause tax liabilities for shareholders who are not trading shares. The process of creating and redeeming shares can trigger capital gains tax liabilities for all fund shareholders.
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ETFs are easier and cheaper to buy

ETFs, like stocks, are available through brokerages. It's easy for the average person to set up a brokerage account and have access to hundreds of ETFs in one convenient place. While you might pay a brokerage fee for trading, ETFs do not have sales charges like many mutual funds.

Costs in general are an advantage for ETFs:

  • ETFs do not have sales charges.
  • Many ETFs follow passive strategies, reducing management expenses.
  • Even newer active ETF strategies try to keep management expenses lower than on a mutual fund, to compete against passive ETFs.
ETFs Mutual funds
Investment diversification?
Available on major brokerages?
Lower fees?
Intraday price visibility
(between 9:30 a.m. and 4:00 p.m. ET)?

As you consider your investment options, you might find that ETFs offer a combination of diversification, low costs, and tax efficiency that is hard to beat.

This quick comparison is just a start. You can learn more about what ETFs and mutual funds can do for you at Putnam.com. Putnam is an asset manager offering active investment strategies to help people succeed.

Disclosure:

These ETFs are different from traditional ETFs. Traditional ETFs tell the public what assets they hold each day. This ETF will not. This may create additional risks for your investment. For example:

You may have to pay more money to trade the ETF's shares. This ETF will provide less information to traders, who tend to charge more for trades when they have less information.

The price you pay to buy ETF shares on an exchange may not match the value of the ETF's portfolio. The same is true when you sell shares. These price differences may be greater for this ETF compared with other ETFs because it provides less information to traders.

These additional risks may be even greater in bad or uncertain market conditions.

The ETF will publish on its website each day a "Tracking Basket" designed to help trading in shares of the ETF. While the Tracking Basket includes some of the ETF's holdings, it is not the ETF's actual portfolio.

The differences between this ETF and other ETFs may also have advantages. By keeping certain information about the ETF secret, this ETF may face less risk that other traders can predict or copy its investment strategy. This may improve the ETF's performance. If other traders are able to copy or predict the ETF's investment strategy, however, this may hurt the ETF's performance.

For additional information regarding the unique attributes and risks of the ETF, see the disclosure below and the Principal Investment Risks section of the prospectus.

Shares of any ETF are bought and sold at market price (not NAV), may trade at a discount or premium to NAV, and are not individually redeemed from the fund. Brokerage commissions will reduce returns.

The funds have limited public-trading history and will operate differently from other actively managed ETFs that publish their portfolio holdings on a daily basis.

Diversification does not guarantee a profit or ensure against loss. It is possible to lose money in a diversified portfolio.

Disclosure:

These ETFs are different from traditional ETFs. Traditional ETFs tell the public what assets they hold each day. This ETF will not. This may create additional risks for your investment. For example:

You may have to pay more money to trade the ETF's shares. This ETF will provide less information to traders, who tend to charge more for trades when they have less information.

The price you pay to buy ETF shares on an exchange may not match the value of the ETF's portfolio. The same is true when you sell shares. These price differences may be greater for this ETF compared with other ETFs because it provides less information to traders.

These additional risks may be even greater in bad or uncertain market conditions.

The ETF will publish on its website each day a "Tracking Basket" designed to help trading in shares of the ETF. While the Tracking Basket includes some of the ETF's holdings, it is not the ETF's actual portfolio.

The differences between this ETF and other ETFs may also have advantages. By keeping certain information about the ETF secret, this ETF may face less risk that other traders can predict or copy its investment strategy. This may improve the ETF's performance. If other traders are able to copy or predict the ETF's investment strategy, however, this may hurt the ETF's performance.

For additional information regarding the unique attributes and risks of the ETF, see the disclosure below and the Principal Investment Risks section of the prospectus.

Shares of any ETF are bought and sold at market price (not NAV), may trade at a discount or premium to NAV, and are not individually redeemed from the fund. Brokerage commissions will reduce returns.

The funds have limited public-trading history and will operate differently from other actively managed ETFs that publish their portfolio holdings on a daily basis.

Diversification does not guarantee a profit or ensure against loss. It is possible to lose money in a diversified portfolio.