I would really appreciate if you answer the question with an easy to understand example
In: Economics
26 year industry veteran here, and while some answers are correct some are simply wrong. Both mutual funds and ETFs are in simple terms, a “basket of stocks” or “basket of bonds”. One of the answers above makes a reference to an S&P 500 index mutual fund, versus an S&P 500 ETF. Both are literally exactly the same 500 stocks. However, there are a couple of key differences:
1. A mutual fund can only be purchased once a day, technically after 4 PM when the market closes and all of the underlying 500 stock prices are set. So if you decide to invest $5000 into XYZ mutual fund today, your purchase will be effective at 4 PM today. Once all the underlying stock prices have been determined in that basket of stocks as of the close of the stock market today at 4 PM.
2. An ETF version of XYZ mutual fund can be bought and sold, or “day traded “, multiple times throughout the day just like you can daytrade a stock.
3. One of the main differences between mutual funds, and ETFs is their tax treatment. Mutual funds are required to pass along capital gains when they sell one of the stocks they have held in that mutual fund, even if you buy the fund today and they sell that position tomorrow. Let’s say you buy XYZ fund today, and they decide to sell Nvidia tomorrow for a 500% gain, but you really only owned that stock for one day. It doesn’t matter, you will pay your prorated capital gains tax on that stock sale even though you only owned it for one day and they may have held it for three years. The other part about a mutual fund, is that in times of panic, where let’s say in 2022 when the market was tanking and people were panicking and getting out of the market, if all of a sudden XYZ mutual fund gets $10 million worth of sell orders and they have to sell off $10 million worth of stock to generate that cash, they’re selling off part of your basket of stocks in which you will owe capital gains on that Nvidia stock sale. However, if it’s a loss, they don’t pass on that loss to deduct on your taxes. This became a big deal in 2022 when the market was down 20%, but some of my clients were still getting tax bills because the underlying mutual fund sold stocks at a gain that they’ve held forever to generate cash for investors.
4. Generally speaking, but not always, you only pay Capital gains taxes on ETFs when you sell them, not when everybody else panics.
5. This really only matters in a taxable brokerage account, this doesn’t matter inside of any IRA or 401k.
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