One of the most popular ways to invest is to make use of funds. Funds offer investors the ability to diversify quickly and easily. Additionally, they can be low-cost, as well as provide investments that can be held over a longer period of time. For the most part, investors have the option to choose between two different types of funds: mutual funds (including index funds) and ETFs.
Both of these funds share some similar characteristics. Mutual funds and ETFs are both linked to the investments held in the funds, and they provide the opportunity to purchase a number of investments at once, in a sort of lot. It is important to note, however, that there are differences between the two.
Mutual funds are collections of investments. These can be actively managed, with managers changing the composition of the fund to meet certain goals, or they can be index-linked, following the investments on a specific index.
For the most part, mutual funds are either open-end or close-end funds:
- Open-End: Shares are purchased, by the investor, from the fund company. Values are determined daily, and there are no limits to the shares issued.
- Close-End: Only a specific number of shares are issued, and the NAV doesn’t determine the price of the fund.
With a mutual fund, the price isn’t figured until the end of the business day, and the NAV is determined. As a result, mutual fund shares are traded differently, and you won’t see them traded the same way a stock is. Additionally, while index funds have relatively low fees, other types of mutual funds often have fairly high rates. Mutual funds can come with sales loads, and an actively managed fund can come with rather high administrative fees.
Finally, it’s important to note that when you want to sell shares in a mutual fund, the fund has to sell shares to pay the investor. Shares sold at a higher price than what they are bought for result in capital gains, which must be distributed to fund shareholders. You might end up paying taxes because of mutual fund turnover.
Exchange Traded Funds (ETFs)
On the other hand, ETFs are a little different. Instead of being a collection of investments, ETFs are composed of units of underlying investments. They are created and redeemed in large lots. And, interestingly, they trade like stocks on the market. This means the price changes regularly, and they are more flexible and easy to trade.
Like mutual funds, you might have to pay a yearly fee, but the fee is often quite small. Plus, there is no need to sell investments held in an ETF when an investor wants to redeem shares. This means that you are unlikely to be surprised by capital gains taxes due to fund turnover. It is also worth noting that the fact that trading can take place at a different price than the NAV, ETFs offer the possibility of arbitrage.
There are three main types of ETF:
- Exchange Traded Open End Index Mutual Fund: Connected to an index, and the dividends are reinvested when received, and paid to shareholders quarterly.
- Exchange Traded Unit Investment Trust: This type of ETF is characterized by the requirement to fully replicate the designated index. There are also weighting and issue requirements, and dividends aren’t reinvested automatically — although they are paid out quarterly.
- Exchange Traded Grantor Trust: Even though this is most similar to a close-end fund, the investor in this type of ETF owns the underlying investments. HOLDRS are good examples of this type of ETF, in which the fund composition remains the same, and there are restrictions on trading.
Make sure you do your research before making any investment decision. Once you understand the differences between an ETF and a mutual fund, you can better make the right decision for you.