Mutual funds and exchange-traded funds (ETFs) are investment vehicles that allow you to hold a diversified portfolio of stocks or track stock market indexes. Mutual funds and ETFs are very different in the way they are priced, sold and managed.
The Traditional Mutual Fund
Conventional mutual funds are managed by individuals with expertise in their particular field, whether it be financial shares, biotechnology, foreign companies, municipal or treasury bonds, or manufacturing firms. They follow different investing philosophies, such as value investing, growth stocks or growth-and-income shares. Investors buy shares through the fund management company. They may be charged sales commissions and regular management fees, and they may be subject to minimum investment amounts. Mutual funds are priced by net asset value or NAV. The NAV is the value of all assets in the fund, divided by the number of shares. It is fixed one time a day, after the market’s close.
Index mutual funds track the daily ups and downs of stock market indices, such as the Standard & Poor’s 500, the Dow Jones Industrial Average and the Russell 2000 (for small-capitalization stocks). These funds are not actively managed; they are simply invested in all the stocks that make up the index. As a result, management fees and sales commissions are usually lower.
What Is an ETF?
Exchange-traded funds are made up of “creation units” that are purchased with large holdings of common stock on the part of an institutional investor, such as a mutual fund or investment bank. They are organized around a single investing philosophy, sector or index. The creation units are then split up into individual ETF shares. The ETF shares are bought and sold on stock exchanges, and their prices rise and fall constantly with investor supply and demand. For example, an ETF investing in the financial sector will tend to track the success or failure of banking and insurance stocks in the market. There are no managers buying or selling individual stocks within the ETF, as in a mutual fund.
ETFs can be bought through brokers or online trading sites, using market orders, limit orders, good-till-canceled orders and other devices that investors can use to control their risk. ETFs can also be sold short, like common shares, if the investor believes a stock index or particular investment sector will fall in value.
Advantage of ETFs
Exchange-traded funds have no minimum investment amount; the investor can buy a single share, subject to the trade commission charged by the broker. Options on ETFs are also available for those who wish to leverage their investment on the possibility of a future rise or fall in the share price. ETFs charge no management or sales fees and pay dividends directly to the investor (mutual funds usually offer the option of using dividends and payouts to buy additional shares).
ETFs are treated much like mutual funds for tax purposes. Investors owe capital-gains tax on any shares sold at a profit, unless they are holding the shares in a conventional IRA or an employer’s 401(k). ETFs can usually avoid the problem of incurring tax liabilities on shares the fund itself sells—which in a conventional mutual fund will be charged to the investor as a fee. ETFs don’t commonly buy or sell underlying shares, unless the index they track drops one of its listed holdings for a different one.