Some people tend to think of exchange-traded funds (ETFs) like single stocks, while others believe they are more akin to mutual funds. There's no question that ETFs share characteristics with both, but understanding the differences is especially important for active traders.
When you invest in an ETF, you are buying into a pooled investment vehicle (similar to a mutual fund), but unlike mutual funds (which allow investors to buy or sell one time each day), ETFs are traded throughout the day on organized stock exchanges (just like common stocks). Most ETFs are passive, which means that they use a published index to determine which securities to hold and how to weight those securities in their portfolios. However, some ETFs are actively managed, and their investment decisions are made by a portfolio manager. Almost every investment niche — from small-cap stocks to emerging market or oil — can be filled by an ETF.
Different sources of liquidity
ETFs, mutual funds and single stocks have different sources of liquidity. When investors purchase or sell shares of mutual funds, they do so directly from fund sponsors at a price calculated at the end of each trading day. This price is called the net asset value (NAV), and the process of transacting directly with a fund sponsor is known as primary market liquidity.
ETFs also offer primary market liquidity, but only for very large transactions conducted by authorized participants (APs). Other investors purchase and sell shares between each other and large ETF dealers (or "market makers") on national stock exchanges (or the "secondary market"). This means that like stocks, ETFs can be bought or sold with standard, equity order types (e.g. market and limit orders), and investors can specify how long an order should be in-force (e.g. day-only, good-until-canceled, fill-or-kill, etc.). ETFs may also be purchased on margin or sold-short, and options (e.g. puts and calls) are also available on many ETFs.
Different transaction and holding costs
Both mutual funds and ETFs earn money for their sponsors via operating expense ratios (or OERs — there is no OER on individual stocks). The OER is an annual rate that the fund charges on the total assets it holds. This fee covers portfolio management, administration and other costs. Selecting ETFs with low OERs is especially important for long-term, buy-and-hold investors since the expense ratio is an ongoing fee. Short-term traders may be more interested in the other costs associated with ETFs — commissions, bid/ask spreads and premiums/discounts to NAV.
On Schwab.com, you can look up any ETF using the Quote Detail page. Scrolling down on the page, you will see the Gross Expense and Net Expense ratios. The Net Expense Ratio is the most useful figure for understanding the current expenses that fund investors are paying. (You should also consider the impact that the gross expense ratio may have on future performance if certain arrangements limiting fees expire or are no longer available.) The figure below shows the exact location of this information.