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Home / Education / Mutual Funds / What Differs an ETF from a Mutual Fund?

What Differs an ETF from a Mutual Fund?

2022-12-07  Maliyah Mah

A comparison of ETFs vs. mutual funds
 

Exchange-traded funds (ETFs) and mutual funds have many characteristics. Both kinds of funds are well-liked methods for investors to diversify because they are made up of a variety of various assets. While mutual funds and ETFs have many similarities, they also differ significantly in a few important ways. ETFs can be exchanged throughout the day like stocks, however, mutual funds can only be bought at the close of each trading day based on a price calculation known as the net asset value. This is a key distinction between the two.

The first mutual fund was introduced in 1924 and has existed in its current form for almost a century. Exchange-traded funds (ETFs) are relative newcomers to the investment world; the SPDR S&P 500 ETF Trust, the first ETF, was introduced in January 1993. (SPY).

ETFs were typically passively managed and tracked market indices or specialized sector indices in the past, whereas the majority of mutual funds were actively managed, meaning fund managers made decisions on how to allocate assets in the fund. The line between the two has blurred in recent years as an increasing number of actively managed ETFs have become available to investors while a major share of mutual funds' assets under management are held in passive index funds.

KEY LESSONS
 

  • Prior to recent years, mutual funds were often actively managed, with fund managers actively purchasing and selling securities inside the fund in an effort to outperform the market and generate profits for investors. However, passively-managed index funds have grown in popularity.
     
  • However, although most ETFs were passively managed because they typically tracked a market index or sector sub-index, an increasing number of ETFs are now actively managed.
     
  • The ability to buy and sell ETFs like stocks, as opposed to mutual funds, which can only be done at the close of each trading day, is a significant difference between the two types of investments.
     
  • Because active management involves higher operating costs than ETFs, actively managed mutual funds often have higher fees and expense ratios than ETFs.
     
  • Mutual funds can either be closed-end, where a fixed number of shares are issued regardless of investor demand or open-ended, where trading takes place between investors and the fund and the number of shares available is unlimited.

Investment funds
 

Compared to ETFs, mutual funds often have a greater minimum investment requirement. Those minimums can change based on the company and type of fund. For instance, the minimum investment for the Vanguard 500 Index Investor Fund Admiral Shares is $3,000. The minimum investment for American Funds' The Growth Fund of America is $250.
 

In order to outperform the market and benefit their owners, many mutual funds are actively managed by a fund manager or team that makes choices to buy and sell stocks or other securities inside that fund. Since they need a lot more time, effort, and labor for research and analysis of securities, these funds are typically more expensive.

Mutual fund purchases and sales are conducted directly between investors and the fund. The net asset value (NAV), which is calculated at the close of each business day, determines the fund's price.

Different Mutual Fund Types
 

For legal purposes, mutual funds fall into one of two categories:

  • Unrestricted Funds. In terms of assets managed and volume, these funds rule the mutual fund industry. In open-ended funds, investors and the fund company deal directly with the purchase and selling of fund shares. The amount of shares that the fund may issue is unlimited. Therefore, more shares are issued as more investors invest in the fund. The daily valuation procedure known as "marking to market" is mandated by federal rules, and it is this process that causes the per-share price of the fund to be modified to reflect changes in the portfolio's (asset) value. The quantity of outstanding shares has no bearing on the value of a shareholder's shares.
     
  • Open-Ended Funds. These funds don't issue additional shares when investor demand increases and only issue a certain number of shares. Investor demand, not the fund's net asset value (NAV), is what determines prices. Shares are frequently bought at a premium or a discount to NAV.
    Before choosing if and how these two investing options fit into your portfolio, it's crucial to consider the various fee structures and tax consequences of each.

Exchange-Traded Funds (ETFs) ETFs can cost as little as the price of one share plus any applicable fees or commissions for an entry position. Institutional investors create or redeem ETFs in huge quantities, and the shares of the ETF move between investors throughout the day just like stocks do. ETFs can be sold short just like stocks. These clauses matter a lot to traders and speculators but not much to long-term investors. However, because ETFs are regularly valued by the market, it is possible for trade to occur at a price different from the true NAV, which may present a chance for arbitrage.

ETFs provide investors with tax benefits. ETFs (and index funds) are passively managed portfolios, which generally experience lower capital gains than actively managed mutual funds.

Through the Numbers
 

As of December 2021, there were $71.1 trillion in regulated open-end funds with 48.1% of all global assets held in mutual funds and exchange-traded funds (ETFs) in the United States.

The Investment Company Institute estimates that by 2021, U.S.-registered mutual funds will have $27 trillion in assets, compared to U.S. ETFs' $7.2 trillion in assets. There were 2,690 ETFs and 8,887 mutual funds in the United States at the end of 2021.

Creation and Redemption of ETFs
 

ETFs are unique from other investment vehicles due to the creation/redemption process, which also offers a variety of advantages. The process of creating an ETF entails purchasing all of the underlying securities and packaging them into the ETF structure. Redemption entails "unbundling" the ETF into its component assets once more.

Authorized participants (APS), who are US-registered broker-dealers with the authority to create and redeem shares of an ETF, work with the ETF sponsor, the entity that issues and manages the ETF, to generate and redeem ETF shares in the primary market. The APS put together the ETF's securities according to their proper weights and delivers them to the ETF sponsor.

 

For instance, an S&P 500 ETF would require the APs to assemble all the S&P 500 constituent stocks according to their weights in the S&P 500 index and deliver them to the ETF sponsor in order to issue ETF shares. After placing these securities in the ETF wrapper, the ETF sponsor distributes the ETF shares to the APS. ETF shares are typically created in significant blocks, such as 50,000 shares. Following their secondary market listing, the new ETF shares begin trading on an exchange-like stock.

The procedure for an ETF redemption is the reverse of an ETF creation. In the secondary market, APs gather ETF shares known as redemption units and deliver them to the ETF issuer in return for the ETF's underlying securities.

ETF Advantages
 

Since the APS actively monitor demand for an ETF and takes prompt action to eliminate material premiums or discounts to the ETF's NAV, the special creation/redemption procedure for ETFs results in ETF prices closely following their net asset value.

A further benefit of the creation/redemption process is that other than when the ETF portfolio needs to be rebalanced, the fund manager of the ETF is not required to buy or sell the underlying stocks of the ETF. Since the exchange of ETF shares for the underlying securities constitutes an "in kind" transaction, an ETF redemption is often tax-exempt, which increases the tax efficiency of ETFs.

ETF from a Mutual Fund
 

As a result, whereas the process of issuing and redeeming shares of a mutual fund may result in capital gains tax implications for all owners, this is less likely to happen for shareholders of an ETF who are not exchanging shares. When ETF shares are sold, it should be noted that the ETF shareholder is still responsible for paying capital gains tax; however, the investor has control over the timing of such a transaction.

Due to the manner in which they are issued and redeemed, ETFs may be more tax advantageous than mutual funds.
3 ETF structure options
 

ETFs can be arranged in one of three ways:

  • Exchange-Traded Open-End Fund: The majority of ETFs are open-end management companies registered under the Investment Company Act of 1940 of the SEC.
    5 This ETF structure has certain diversification restrictions, such as the portfolio's maximum allocation to securities of a single stock being capped at 5% of the total.
     
  • Due to the fact that it is not necessary for this structure to completely replicate an index, it provides more portfolio management flexibility when compared to the Unit Investment Trust structure. Instead of owning each individual component security in the index, many open-end ETFs use optimization or sampling algorithms to mimic an index and match its features. Dividend reinvestment in new securities is also permitted for open-end funds until shareholder payouts are made. Derivatives may be employed in the fund, and securities lending is permitted.
     
  • Trust for Exchange-Traded Units (UIT). The Investment Company Act of 1940 also applies to exchange-traded UITs, but these must make an effort to completely replicate their particular indexes in order to reduce tracking error, cap investments in a single issue at 25% or less, and establish additional weighting limits for diversified and non-diversified funds.

    8 The initial ETFs had a UIT structure, like the SPDR S&P 500 ETF. UITs pay cash dividends on a quarterly basis rather than automatically reinvesting dividends.
    5 They are not permitted to possess derivatives or engage in securities lending.

    Examples of this structure are the Dow Diamonds and QQQQ (DIA).
     

Grantor Trust with Exchange. The optimal structure for commodity-focused ETFs is the one described above. This grantor trust-structured ETFs are registered under the Securities Act of 1933 but not the Investment Company Act of 1940 because they are grantor trusts. This kind of ETF is quite similar to a closed-ended fund, except the investor owns the actual shares of the businesses the ETF invests in. This includes having shareholder-associated voting rights. However, the fund's makeup remains unchanged. Dividends are paid out directly to shareholders rather than being reinvested. Investors must transact in quantities of 100 shares. These ETFs include holding company depository receipts (HOLDRs), for instance.
Example of Mutual Fund vs. ETF Redemption 10
Take a $50,000 redemption from a typical Standard & Poor's 500 Index (S&P 500) fund as an illustration. The fund must sell $50,000 worth of stock in order to compensate the investor. If an investor sells appreciated stocks to raise cash, the fund collects the capital gain and distributes it to shareholders before the end of the fiscal year.

As a result, shareholders are responsible for paying the tax on fund turnover. The ETF does not sell any portfolio stocks in response to a $50,000 redemption request from an ETF shareholder. Instead, it provides "in-kind redemptions" to shareholders, which reduces the likelihood of paying capital gains.
Is Investing in the Market Through an ETF or Mutual Fund Better?
The primary distinction between an ETF and a mutual fund is the latter's intraday liquidity. So the ETF might be a better option if the ability to trade like a stock is a key factor for you.

Do ETFs Carry More Risk Than Mutual Funds?
 

Despite having somewhat distinct constructions, mutual funds and ETFs that otherwise follow the same strategy or track the same index are not always riskier than one another. Instead of the investment's structure, the underlying holdings of a fund determine how risky it is in major part.

Given the Same Passive Strategy, Are There Different Fees for Index ETFs and Mutual Funds?
In many instances, the difference in fees now is negligible. For instance, the expense ratio for some of the biggest and most well-liked S&P 500 ETFs is 0.03%. The cost ratios for the Vanguard 500 Index Fund Admiral Shares (VFIAX) and the S&P 500 ETF (VOO) are 0.03% and 0.04%, respectively.
 

Are Dividends Paid by ETFs?
 

Indeed, a lot of ETFs will distribute dividends based on the dividend payments of the equities the fund owns.

Have Index Funds Increased in Popularity Recently?
 

Mutual funds or exchange-traded funds (ETFs) can be used to create index funds, which follow the performance of a market index. These two index fund categories' combined net assets increased from $9.9 trillion in 2020 to $12.5 trillion in 2021. At year-end 2021, index mutual funds and index ETFs collectively represented 43% of assets in long-term funds, doubling their proportion from 21% ten years earlier.

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2022-12-07  Maliyah Mah