As far as diversification is considered, ETFs, short for exchange-traded funds, and mutual funds have proven to be quite popular. But there are a couple of notable differences. ETFs are capable of being traded intraday like stocks. Mutual funds, on the other hand, are purchased mainly at the trading day’s end, with the prices calculated based on the net asset value, or NAV, for short.
Mutual funds have been here for quite a while now, over a century, to be exact, with the first fund releasing in 1924. However, ETFs are comparatively new entrants in the investment landscape. This is evident when you consider how the first ETF launched in 1993, known as the SPY, short for SPDR S&P 500 ETF Trust.
In mutual funds, it’s the fund managers deciding how assets are to be allocated, so a lot of these funds are usually managed actively. ETFs tend to be managed passively most of the time. They track either specific sector indexes or market indexes. But be that as it may, there are a growing number of ETFs that are being actively managed. But the mutual funds that are passively managed are known as index funds, and they have lower fees too.
What are Mutual Funds?
Mutual funds usually come with higher requirements for minimum investments when compared to ETFs, though funds with zero minimum investments do exist. In other words, minimums vary depending on the fund or company in question.
Most of the time, the mutual funds you come across, fund managers, or entire teams are the ones actively managing them, deciding how many or what kind of stocks to purchase or sell in those funds so that their investors may profit when they beat the market. Naturally, these funds will have greater costs since they’ll need substantially more manpower, time, and effort for analyzing and researching securities.
Sales and purchases of mutual funds directly happen between the funds themselves and the investors it has garnered. As highlighted previously, the price of the fund isn’t determined until the business day ends, which is also when the NAV is acquired.
The Two Main Mutual Fund Types
From a legal point of view, mutual funds tend to be divided into two main categories, which are close-ended and open-ended. Their differences primarily boil down to fund shares.
Inside the mutual fund marketplace, you’ll find open-ended funds dominating in both volume and assets under management. Sales and purchases of fund shares occur between fund companies and investors directly. There aren’t any limits to how many shares that the fund is able to issue here. More shares may therefore be issued as more and more investors buy into it.
As for close-ended funds, they’re the complete opposite, with only specific amounts of shares being issued. New shares aren’t issued with growing investor demand. Prices will not be determined by the fund’s NAV. They will instead be primarily determined by investor demand instead. Share purchases are made typically at a discount or premium to the NAV.
ETFs
ETFs may cost quite a bit less for entry positions, at times as little as a single share costs, including any commissions or fees. ETFs are created or redeemed in big lots by institutional investors, with the shares trading between investors during the day like stocks. ETFs may be sold short too.
These provisions can be vital to speculators and traders, but long-term investors may not be as interested. However, ETFs are continuously priced by the market, so there is the possibility of trading taking place at prices different from the actual NAV. This can bring in opportunities for arbitrage.
ETFs can provide tax benefits to investors. As a passively managed portfolio, an index fund or ETF usually realizes fewer capital gains in comparison to actively managed mutual funds.
How ETFs are Created and Redeemed
The creation or redemption procedure of ETFs differentiates them from other investment mediums and offers numerous benefits. Creation involves purchasing every single underlying security that comprises the ETF and then bundling them within the ETF structure. Redemption involves the exact opposite, i.e., unbundling that ETF back into those single securities.
The ETF redemption and creation procedure happens within the primary market, taking place between APs, i.e., authorized participants, and the ETF sponsor. The APs assemble securities that are included inside the ETF within their correct weights, then deliver the securities to those ETF sponsors.
The sponsors are the fund managers and ETF issuers that market and administer ETFs. As for authorized participants, they include US-registered broker-dealers who have the right to generate and redeem the shares of ETFs.
Which Should you Invest in?
Should you invest in ETFs or mutual funds? Well, that choice could depend on various factors. ETFs provide better trading control and flexibility, as they may be purchased and sold like stocks over the trading day. They tend to be more tax-effective too because of the manner in which they trade. As for mutual funds, they might provide longer histories, which may help one evaluate performance.
When you are researching funds, it is vital to consider the expense ratio of the fund, its trading commissions, and any target asset allocations you may have, like the blend of bonds, stocks, and cash that you should be holding within your portfolio.
Speaking of expense ratios, ETFs are typically the more affordable investments. Mutual funds usually have requirements pertaining to minimum investments, which can be hundreds, if not thousands, of dollars. You may invest within an ETF if you possess enough funds to buy single shares. ETFs are also passively managed. Mutual funds can be actively or passively managed, but a lot tend to be the former, so you’ll find ETF expense ratios to be lower.
Final Thoughts
Though ETFs and mutual funds can be very different in some ways, they both expose investors to a diversified bundle of securities, and so they can be decent investment vehicles to help achieve your investing objectives. As an investor, it is you who has to select what best suits your needs, no matter if it’s an open-ended mutual fund, an ETF, or some blend of both.
