With progress comes innovation. Exchange-traded funds (ETFs), barely 20 years old, are among the more recent innovation to come off the managed money assembly line. By contrast, the mutual fund dates back to the 1920s, surviving the Great Depression and numerous recessions, including the most recent and, arguably, most severe, of the past several years. The Investment Company Institute (ICI), a professional association for the investment company industry, reports that ETFs for all asset classes as of November 2011, clocked in over $1 trillion, versus close to $11.8 trillion for mutual funds. Of the total $12.652 trillion, ETFs comprise a bit over 8%, quite ascendant for a mere 20 years. However, mutual funds make up the remaining 92%.

See: A Brief History Of Exchange-Traded Funds

Which Is Better?
It depends upon the type of investor. The traditional, less sophisticated IRA investor who reallocates strategically, rather than tactically, keeps expenses low and is not a stock picker, may find the process of purchasing shares from a mutual fund company and redeeming them a simpler process. Additionally, plan sponsors' use of mutual funds is well entrenched. Indeed, the ICI reports in its 2011 Investment Company Fact Book that close to $5 trillion is invested in open-end mutual funds within IRAs and defined contribution plans.

Individual ETF investors, on the other hand, tend to be more sophisticated, owning individual securities in both their tax qualified and non-qualified accounts, alike. Institutional investors use them, as well. ETFs trade throughout the day, may be purchased on margin and sold short. ETFs also afford the investor exposure to myriad markets and asset classes. Most are passive investments (track an index), but some offer active and complex approaches.

Institutional managers (separate accounts, hedge funds) that use leverage, take directional bets, hedge (pairs trading and market neutral strategies) or tactically allocate asset classes, use ETFs that prove to be less expensive and more nimble. These vehicles are more transparent than their closed-end fund (CEF) forebears, which lack the authorized participant, a built in market making device. This feature of the ETF allows for daily creation and redemption of shares, which minimizes differences between the ETF price and its net asset value (NAV). CEFs issue a fixed number of shares, in contrast, which lead to continued differences between the share price and the NAV, creating an arbitrage opportunity.

Other Considerations
ETFs continue their innovation, offering active management and funds of funds (an ETF pursuing a strategy by investing in other ETFs). Some go further out along the risk continuum with the advent of synthetic ETFs, for which return comes from a swap rather than an index, ETNs (exchange traded notes), which hold fixed income, and ETVs (exchange traded vehicle), which are similar to ETNs, but issued through a special purpose vehicle to gain access to more opaque markets. Here counterparty risk exists. Finally, there are leveraged ETFs and inverse ETFs that track the opposite performance of an index, effectively making a directional bet. The aforementioned suite of products is best reserved for the more sophisticated risk-aware investor.

Depending upon the investor, exchange traded funds may have possible drawbacks. No-load mutual fund investors would need to open a brokerage account and pay commissions to trade. Frequent, small investments that are part of a dollar-cost averaging strategy could prove to be more expensive. Additionally, investors need to understand that passive ETFs are subject to tracking error, some to a greater degree than others, where the manager may not be able to purchase some illiquid securities in the index and must attempt index replication through sampling the liquid securities in it. Product complexity is always a consideration.

Investors must also understand differences in settlement procedures. Whereas mutual funds settle next-day, ETFs settle in three business days. The investor must have cash on hand to pay for purchases. Retail investors would be more likely to find these differences a challenge than institutional ones. Below is a table that better illustrates the differences between the two financial instruments.

ETF Mutual Fund
Daily and continuous pricing Forward pricing
Exchange traded Fund redemption at day\'s end
No tax effect of trading on shareholders Large redemptions may cause capital gains distributions for non-redeeming fund shareholders
In-kind redemption reduces shareholder tax liability Fund managers limited in their ability to manage taxes due to cash redemptions
Limit, stop limit orders, short selling allowed No limit order pricing or short selling permitted
May be purchased and sold on margin No margin trades allowed
Lower expense ratios as client services born by brokerage firms Expenses tend to be higher due to sales loads
May be purchased in any brokerage account Fund availability depends on existence of selling agreements with the broker/dealer
Brokerage commissions applicable No-load funds purchased directly have no transaction costs, load funds through a broker often have sales charge or commission

The Bottom Line
Whatever choice investors make, they need to have a clear picture of their objectives and constraints, either through simple data gathering or more elaborate work with an investment advisor who can put together an Investment Policy Statement. Additionally, as with any investment, investors need to understand the risk and return profile of the asset classes in which they plan to invest and how the instruments work. Once they do, the choice of mutual fund or exchange-traded fund is simply a matter of implementation.

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