Exchange traded funds have gained tremendously in popularity over the past 20 years with both professional and individual investors. Yet questions still arise frequently as to how an ETF differs from a conventional mutual fund.
Mutual funds still dominate the investment landscape for individual Americans, holding more than $15 trillion in assets, according to the Investment Company Institute. While the concept of pooling investments from individuals is at least 250 years old, the modern incarnation of the mutual fund began in 1924 with the Massachusetts Investors' Trust, now known as MFS. Today, more than 10,000 funds address myriad objectives and provide convenient access to diversification and professional management.
The majority of these vehicles are known as open-end funds, which create or extinguish shares as money flows in or out from investors in the fund. At the end of each trading day, the closing value of all the fund's holdings of stocks and bonds is tallied up and divided by the total number of fund shares. This value, called the net asset value is the share price reported to individual fund holders for that day. Any fund purchases or sales occur at the end of the day at the NAV.
Like mutual funds, ETFs aggregate investor funds to buy a basket of stocks or bonds, but they differ in structure. ETFs trade in real time throughout the day on the major stock exchanges. And although the ending NAV is compiled each day, this value does not directly determine the market price of the units.
Most ETFs attempt to replicate an index like the S&P 500, or to mimic the performance of a specific sector such as energy or financials. Recently, new varieties have sprung up that utilize leverage or move in the opposite direction from an index (or both), although these exotic flavors should be avoided by most investors as there are many more enjoyable ways to deplete wealth.
Compared to their mutual fund brethren, index ETFs can be cheaper to own. Mutual funds assess charges for marketing their products [so-called 12B-1 fees], and may include sales loads as well, while ETF buyers pay standard stock trading commissions. Investors can even trade many index ETFs commission-free at many discount brokerages. Of course the cost advantage over basic index mutual funds is typically small and can disappear if a high trade commission is attached.
For investors who question the efficacy of active management, index ETFs offer an excellent alternative. Morningstar estimates that expenses for actively managed mutual funds average 1.45 percent per year, compared to 0.6 percent annually for the ETF universe, and as low as 0.04 percent for an S&P 500 ETF. If you doubt the ability of fund managers to consistently beat the market, minimizing costs should be your top priority and index ETFs fit the bill.
Another important advantage of the ETF structure is tax efficiency. Gains and losses realized within a mutual fund are generally reported each year to the holders, like it or not. ETFs by virtue of their structure avoid most of these pass-through distributions, allowing shareholders to realize capital gains or losses on their own time frame when and if they sell the ETF.
For 401(k) plans, mutual funds still dominate since the internal marketing fees often contribute to covering administrative costs of the plan. This may change over time as regulators require more transparency in reporting plan expenses, but is unlikely to happen soon.
For individual investors, however, especially in taxable accounts, ETFs may be a better alternative to traditional funds.
Christopher A. Hopkins, CFA, is vice president and portfolio manager for Barnett & Co., in Chattanooga.