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Asked & Answered: ETFs vs Mutual Funds

June 7, 2012

Stacy from Sedona, AZ:

 

What is the difference between an ETF and a Mutual Fund?

 

Friedenthal Financial:

 

There are a number of similarities, as well as some pronounced differences.  We’ll highlight both below, as well as differences to ETNs (Exchange Traded Notes).

 

The primary similarity, which makes all of these structures popular, is that they represent a basket of securities that are purchasable in one fell swoop.  Each fund generally holds several (and some as many as thousands) stocks, bonds, futures, or commodities (sometime more than one asset class).

 

The most common Mutual Fund Structure is called an Open-end Fund.  If you want to buy or sell shares of an Open-end Mutual Fund, you must do so DIRECTLY with the Mutual Fund Company.  You will pay or receive the Net Asset Value of the assets held by the Fund, at the end of the day (even if you place your order at the beginning of the day).  It should be noted that the tax consequences of this structure can leave something to be desired, because redemptions by other investors (selling shares back to the Mutual Fund) can cause the Fund to need to sell some assets, to effectively buy back these shares.  This can create a taxable event for the Fund, and thus its remaining owners.  So, you could get hit with a tax obligation, even though you didn’t own shares during the period of appreciation.  The other complaint about this structure is that panic exits cause more assets to be sold, which can perpetuate the panic.

 

There are also Closed-end Mutual Funds.  This structure is a corporation that raises capital through an IPO and then invests in a basket of securities.  The main difference (which is significant) is that a Closed-end Fund then trades on the exchange like a stock, throughout the day.  It rarely gets larger or smaller (only through a secondary offering), as an Open-end Fund would through purchases and redemptions.  It should also be noted that a Closed-end Fund can deviate materially in price from its Net Asset Value.  Some thoughts on why, are that the assets themselves may not be so liquid as to have a definitive value.  In some cases a Closed-end Fund uses leverage (borrowing), which may be at some higher cost, causing a depleted value in the market.

 

An Exchange Traded Fund (ETF) is a Corporation which also owns a basket of securities AND trades on an exchange (hence the clever name) throughout the day.  The one thing it has in common with an Open-end Mutual Fund is that the outstanding shares can grow (or shrink) materially.  This is accomplished by virtue of large institutional players that have the ABILITY to swap the underlying holdings (in prescribed proportions) for shares in the ETF (creation units).  This is what also tends to keep ETFs in line with the Net Asset Value of their assets (because large deviations cause these players to the exchange underlying assets for shares in the ETF).  That said, there can still be deviations between share prices and NAV for a given ETF.  Generally speaking, the more liquid the underlying assets are, the smaller the deviation.  ETFs tend to be more tax efficient than Open-end Funds because sales can be made to other market participants.

An Exchange Traded Note (ETN) is actually a general obligation of an institution (usually a large Broker/Dealer) to pay the owner a return equal to that of a specified index.  It also trades on an exchange, throughout the day.  The allure is that it is perfectly tax efficient, since there would be no actions which trigger any taxable events.  The one notable issue is that in addition to the market risk of the securities, the owner is ALSO taking the credit risk of the ISSUER.

 

A few additional notes………

 

The costs of Mutual Funds, ETFs, and ETNs can vary materially.  Carefully examine any Front Loads/Back Loads/Early Redemption Fees (Mutual Funds), Commissions (ETFs & ETNs), and Expense Ratios (all Funds) to get the comprehensive picture of costs.

 

Varying liquidity (ability to enter and exit a position at a very narrow spread) among Closed-end Funds, ETFs, and ETNs can be substantial.

 

We hope that helps and provides fodder for discussion. Please let us know if we can be of further service!

 

The Friedenthal Financial Team

856-210-6494 (Office)

856-210-1565 (Facsimile)

info@friedenthalfinancial.com

www.friedenthalfinancial.com

 

Please send us your questions!! If we don’t know the answers, we’ll find someone who does!

 

If you know someone who would like to discuss their investment needs with us, we certainly appreciate the introduction.

 

This blog is only intended to provide answers to questions of general interest we receive on the topics of investments, finance, capital markets, and economics and to serve as a historical repository for our e-mailed Asked & Answered column. We are not rendering or offering to render personalized investment advice or financial planning advice through this blog or any of its attached links. Friedenthal Financial will render investment advice to potential clients only after: (i) we have delivered a disclosure statement to the potential client as required under applicable securities laws, and (ii) the potential client has executed and delivered Friedenthal Financial’s investment advisory contract to us. We will provide investment advisory services to clients only in states in which Friedenthal Financial is registered as an investment adviser or is exempt from registration.