The similarities between mutual funds and exchange-traded funds (ETFs) are striking. Both types of funds are made up of a variety of assets and are a popular approach for investors to diversify their portfolios. While mutual funds and exchange-traded funds are similar in many ways, they also have some significant distinctions. ETFs, unlike mutual funds, can be exchanged intraday like stocks.
The first mutual fund was in 1924, and mutual funds have been around in their current form for almost a century. Exchange-traded funds (ETFs) are relatively new to the investment world, with the first ETF, the SPDR S&P 500 ETF Trust, debuting in January 1993. (SPY).
Most mutual funds were actively managed. It meant that fund managers made decisions on how to distribute assets within the fund. Whereas ETFs were mostly passively managed and tracked market indices or particular sector indices. This distinction has blurred in recent years, as passive index funds account for a large share of mutual fund assets under administration. While actively managed ETFs are becoming more widely available.
Mutual funds have a greater minimum investment requirement than exchange-traded funds (ETFs).
Depending on the type of fund and company, these minimums may differ.
The Vanguard 500 Index Investor Fund, for example, demands a $3,000 minimum commitment, but American Funds’ GrowMany mutual funds are actively managed, with a fund manager or team making choices to buy and sell stocks or other securities inside the fund in attempt to outperform the market and profit their investors.
These funds are frequently more expensive since they require significantly more time, effort, and labor for security research and analysis. th Fund of America requires a $250 initial deposit.
Two Kinds of Mutual Funds
There are two legal classifications for mutual funds:
- Open-Ended Investment Funds (OEIFs) are a type of OEIF. In terms of volume and assets under management, these funds dominate the mutual fund industry.
The buying and sale of fund shares takes place directly between investors and the fund company with open-ended funds. The number of shares that the fund can issue is unlimited. As a result, as more people invest in the fund, more shares are issued. Marking to market is a daily valuation process mandated by federal laws that adjusts the fund’s per-share price to reflect changes in portfolio (asset) value. The number of shares outstanding has no bearing on the value of an individual’s shares.
- Closed-End Funds (CEFs) are mutual funds that are not open to the public.
These funds only issue a limited number of shares and do not issue more as investor demand increases.
Prices are determined by investor demand rather than the fund’s net asset value (NAV).
Shares are frequently purchased at a premium or discount to NAV.
Exchange-Traded Funds (ETFs)
The cost of an entrance position in an ETF can be as low as the cost of one share, plus fees or commissions.
Institutional investors create or redeem ETFs in huge quantities, and the shares trade like stocks amongst investors throughout the day. ETFs, like stocks, can be sold short. Traders and speculators will be interested in these measures, but long-term investors will be less so. However, because ETFs are constantly priced by the market, there’s a chance that trading will take place at a price other than the genuine NAV, opening up the possibility of arbitrage.
ETFs provide tax benefits to investors. ETFs (and index funds) have lower capital gains than actively managed mutual funds because they are passively managed portfolios.
ETF Creation and Redemption
ETFs distinguish from conventional investment vehicles by their creation/redemption procedure, which offers a number of advantages. The process of creating an ETF entails purchasing all of the underlying securities that make up the ETF and bundling them into the ETF structure. The process of redemption entails “unbundling” the ETF into its individual securities.
The ETF creation and redemption procedure takes place in the primary market between the ETF sponsor – the ETF issuer and fund manager that manages and markets the ETF – and authorized participants (APs). The APs construct the ETF’s securities in the relevant weights and deliver them to the ETF sponsor. For example, an S&P 500 ETF would require the APs to assemble all of the S&P 500 constituent equities and send them to the ETF sponsor based on their weights in the S&P 500 index.
After that, the ETF sponsor packages these securities into an ETF wrapper and distributes the ETF shares to the APs.
The procedure of ETF redemption is the polar opposite of ETF creation.
In the secondary market, APs collect ETF shares known as redemption units and deliver them to the ETF issuer in exchange for the ETF’s underlying securities.
Because the APs regularly monitor demand for an ETF and act quickly to minimize substantial premiums or discounts to the ETF’s NAV, the unique ETF creation/redemption process results in ETF prices closely following their net asset value.
The ETF’s fund manager does not have to acquire or sell the ETF’s underlying securities except when the ETF portfolio needs to be rebalanced because of the creation/redemption procedure.
Because an ETF redemption is a “in kind” transaction in which ETF shares are swapped for the underlying securities, it is usually tax-free, making ETFs more tax-efficient.
Note that when ETF shares are sold, the ETF shareholder is still liable for capital gains tax; however, the investor can choose when to sell.
Mutual Fund vs. ETF Redemption Example
Consider the case of a $50,000 redemption from a typical Standard & Poor’s 500 Index (S&P 500) fund. The fund must sell $50,000 worth of stock to compensate the investment.
If an investor sells appreciated equities to free up cash, the fund captures the profit and distributes it to owners before the end of the year. As a result, shareholders are responsible for the fund’s turnover taxes. The ETF does not sell any equity in the portfolio if an ETF shareholder intends to redeem $50,000. Rather, it offers “in-kind redemptions” to shareholders, which limit the potential of paying capital gains.
Three Structures of ETFs
There are three structures of ETFs:
- The great majority of ETFs are open-end management firms, as defined by the Securities and Exchange Commission’s Investment Company Act of 1940. This ETF structure has certain diversification rules.
In comparison to Unit Investment Trusts, this structure allows for more portfolio management freedom. As a result, rather of holding every single constituent securities in the index, a number of open-end ETFs use optimization or sampling algorithms to duplicate an index and match its features. Dividends can also reinvest in additional assets by open-end funds until they are distributed to shareholders. Securities lending is permitted, and the fund may employ derivatives.
- Exchange-Traded Unit Investment Trusts (ETUITs) are a type of unit investment trust (UIT).
UITs were used to structure the earliest ETFs, such as the SPDR S&P 500 ETF. Dividends don’t automatically reinvest in UITs; instead, they are paid out in cash quarterly. They are not permitted to lend or own securities or derivatives. The QQQQ and Dow DIAMONDS are two examples of this structure (DIA).
- Grantor Trus- traded on the stock exchange. ETFs that invest in commodities should use this structure.
Grantor trusts, which are registered under the Securities Act of 1933 but not the Investment Company Act of 1940, are used to form these ETFs. This sort of ETF resembles a closed-ended fund in appearance. However the underlying shares in the companies in which the investor ownes the ETF invests. This includes the voting privileges that come with being a shareholder. However, the fund’s makeup remains unchanged. Traders must buy and sell in 100-share lots. One example of this form of ETF is holding company depository receipts (HOLDRs).