Wealth in our Woods Column: WTF is an ETF?
What are exchange-traded funds?
By Kyle Green, CFP®, Sherwood Wealth Management
SHERWOOD, Ore. — If you have been following this column, you have learned about long-term investing, stocks, bonds, and diversification through mutual funds - particularly index funds. Originally, I intended to jump directly into ETFs, but I realized it was important to first understand what mutual funds are, why investors use them, and how they fit into a long-term investment strategy. With that foundation in place, it is time to explore the ETF and why it has become such a popular investment vehicle.
Mutual funds and exchange-traded funds (ETFs) are very similar. So much so, that mutual funds will often have an ETF counterpart that shares the same underlying portfolio. That means they own the same investments, follow the same index, and usually perform similarly, before taxes and fee differences. For example, VFIAX, a Vanguard mutual fund, has an ETF equivalent, VOO — and both track the S&P 500.
How are ETFs different?
An ETF is traded on an exchange — hence the name exchange-traded fund. That’s the big takeaway here.
What does that mean?
Mutual funds are valued based on Net Asset Value (NAV), which is the total value of the fund’s holdings, minus liabilities, divided by the number of shares outstanding. In simpler terms, if the mutual fund was a pizza, the NAV would be the value of each slice.
Unlike stocks, mutual funds do not trade continuously throughout the day — all buy and sell orders are processed after market close, and the fund calculates NAV one time per day. So, if I put in an order to purchase 100 shares of a mutual fund, that order is not filled until the end of the day.
Conversely, ETFs are traded on an exchange, so the price can change multiple times during the day. Their value is still based on NAV, but buyers and sellers determine the current trading price, meaning the price can temporarily be higher or lower than NAV. While that may not seem like a huge difference, it gives ETFs characteristics that can make them more attractive than mutual funds.
Because ETFs trade on an exchange, they generally have no minimum investment requirement - investors can often purchase just a single share. Mutual funds frequently require minimum initial investments. ETFs often have lower expense ratios than comparable mutual funds.
Another advantage is tax efficiency. Mutual funds can distribute capital gains to shareholders even if the investor never sold shares themselves, potentially creating an unexpected tax bill. With ETFs, investors generally realize capital gains tax when they choose to sell their shares, making ETFs more tax-efficient than traditional mutual funds.
Finally, ETFs offer greater flexibility. Because they trade throughout the day on an exchange, investors can buy or sell shares during market hours and utilize trading tools such as limit orders and stop orders — features generally unavailable with traditional mutual funds.
Ultimately, the differences between mutual funds and ETFs are not nearly as important as the principles behind them. Whether you choose a mutual fund or an ETF, what matters most is building a diversified portfolio, keeping costs low, and staying invested for the long term.
The best investment vehicle is often the one that helps you remain disciplined through the ups and downs of the market. ETFs have become popular because they offer flexibility, low costs, and tax efficiency, but they are ultimately just another tool investors can use to pursue long-term financial goals. Like so many aspects of investing, success is usually less about finding the perfect product and more about developing the patience and discipline to stick with a sound plan over time.
