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Exchange-traded funds (ETFs) were once described as the new kids on the investment block, but today they are giving traditional mutual funds a run for their money. Both ETFs and mutual funds are viable choices for investors. But, with many mutual funds and ETFs available on the market, it's important for investors to familiarize themselves with the differences between products to ensure they are making appropriate investment decisions. While mutual funds and ETFs share similar traits, there are differences between the two that investors must consider when deciding which to use. Read on to find out.
Legal Structure of Funds
Both mutual funds and ETFs can vary in terms of their legal structure. Mutual funds can typically be broken down into two types.
- Open-Ended Funds - These dominate the mutual fund marketplace in terms of volume and assets under management. With open-ended funds, purchases and sales of fund shares take place directly between investors and the fund company. There's no limit to the number of shares the fund can issue; as more investors buy into the fund, more shares are issued. Federal regulations require a daily valuation process, called marking to market, which subsequently adjusts the fund's per-share price to reflect changes in portfolio (asset) value. The value of the individual's shares is not affected by the number of shares outstanding.
- Closed-End Funds - These funds issue only a specific number of shares and do not issue new shares as investor demand grows. Prices are not determined by the net asset value (NAV) of the fund, but are driven by investor demand. Purchases of shares are often made at a premium or discount to NAV. (For related reading, see Closing Funds: Investment Protection Or Trap? and Open Your Eyes To Closed-End Funds.)
Legal Structure of ETFs
An ETF will have one of three structures:
- Exchange-Traded Open-End Index Mutual Fund - This fund is registered under the SEC's Investment Company Act of 1940, whereby dividends are reinvested on the day of receipt and paid to shareholders in cash every quarter. Securities lending is allowed and derivatives may be used in the fund.
- Exchange-Traded Unit Investment Trust (UIT) - Exchange-traded UITs are governed by the Act of 1940 also, but must attempt to fully replicate their specific indexes, limit investments in a single issue to 25% or less, and sets additional weighting limits for diversified and non-diversified funds. UITs do not automatically reinvest dividends, but pay cash dividends quarterly. Some examples of this structure include the QQQQ and Dow DIAMONDS (DIA).
- Exchange-Traded Grantor Trust - This type of ETF bears a strong resemblance to a closed-ended fund but, unlike ETFs and closed-end mutual funds, an investor owns the underlying shares in the companies that the ETF is invested in, including the voting rights associated with being a shareholder. The composition of the fund does not change; dividends are not reinvested but instead are paid directly to shareholders. Investors must trade in 100-share lots. An example of this ETF are holding company depository receipts (HOLDRs).
Trading Process
ETFs offer greater flexibility than mutual funds when it comes to trading. Purchases and sales take place directly between investors and the fund. The price of the fund is not determined until end of business day, when net asset value (NAV) is determined. An ETF, by comparison, is created or redeemed in large lots by institutional investors and the shares trade throughout the day between investors like a stock.
Like a stock, ETFs can be sold short. Those provisions are important to traders and speculators, but of little interest to long-term investors. But, because ETFs are priced continuously by the market, there is the potential for trading to take place at a price other than the true NAV, which may introduce the opportunity for arbitrage. (To learn more about arbitrage, read Arbitrage Squeezes Profit From Market Inefficiency.)Expenses
Due to the passive nature of indexed strategies, the internal expenses of most ETFs are considerably lower than those of many mutual funds. Of the more than 650 available ETFs listed on Morningstar in 2008, those with the lowest expense ratios included the Vanguard Large Cap ETF and Total Market ETF, both tied at .07%, while the highest expense fund was the Goldman Sachs Connect GSCI ETN at 1.25%. By comparison, the lowest fund fees range from .05% to more than 10% per year for other funds. (For more on mutual fund feeds, read Stop Paying High Fees.)
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