Personal Finance: ETFs versus Mutual Funds -- what's the difference?

Photo — Please put this mug shot of Chris Hopkins of Barnett & Co. in our system to use every other Wednesday when it will run with his column.

In 1928, Calvin Coolidge was president, Shirley Temple was born, and Americans were introduced to the first publically available mutual fund, the Massachusetts Investors' Trust. Today, most investors are well-acquainted with mutual funds, to the tune of $16 trillion in over 7,900 different funds pursuing hundreds of stated objectives.

In 1993, Bill Clinton is inaugurated, Microsoft released Windows 3.1, and the first Exchange Traded Fund, the SPDR S&P 500 index fund, opened for business. Since then, over 1,400 ETFs have garnered nearly $2 trillion in the United States alone, and now offer investors myriad low-cost options for building diversified portfolios. Mutual funds and ETFs each possess advantages and limitations, so understanding the difference is an essential first step.

photo Chris Hopkins of Barnett & Co.

Similar to traditional mutual funds in concept, ETFs differ both in how they are traded and how they are constructed. Both vehicles serve to pool capital from individual or institutional investors and utilize that capital to invest in a broader portfolio of individual stocks, bonds, commodities and other financial assets. The differences appear when examining how the funds are purchased and redeemed.

Mutual funds create and dissolve shares directly in response to net inflows or outflows of capital from customers. Investors send cash to the mutual fund either directly by check or electronic transfer, or indirectly through a broker or bank intermediary that forwards the cash on to the fund. Additional shares in the fund are immediately created each day as new money arrives. The inflows are then used to purchase more of the underlying securities already held by the fund.

Net outflows of cash trigger the expunction of shares in a reversal of the process. The fund manager sells shares from its portfolio, dissolves the requisite number of shares, and forwards the cash to the clients who requested the sale. At no time do the fund shares actually trade or change hands from one investor to another. All transactions occur in the primary market, directly between the issuer and the investor.

These purchase and redemption activities occur at the end of each trading day, after all market activity has ceased, at the "net asset value" or total closing value of all the underlying securities. Orders entered during the day are held until the close before pricing and execution.

Exchange traded funds, perhaps not surprisingly, trade on an exchange. Thank you, Captain Obvious. But this distinction gives them interesting and useful properties distinct from mutual funds.

ETFs are bought and sold throughout the trading day on a stock exchange, exactly like individual stocks. Intraday prices are determined through the interplay of supply and demand. A buyer of a share in an ETF is trading with a seller of the same security, completely removed from the fund company. This is known as a secondary market transaction, just like giving your broker an order for 100 shares of IBM.

New shares are created in lots of 25,000 to 250,000 by large banks and brokerages (known as sponsors or market makers) in response to overall demand. The newly created shares are released at net asset value to stock exchanges to begin secondary market trading. Sponsors also redeem and extinguish shares to maintain market balance if demand wanes. The shares are backed by a basket of the underlying securities placed on deposit at a custodial bank. Thus the ETF that actually trades is technically a "depository receipt" that represents fractional ownership in a physical collection of stocks or bonds.

Next week we will delve into the relative benefits and disadvantages of ETFs and mutual funds.

Christopher A. Hopkins, CFA, is a vice president and portfolio manager for Barnett & Co. in Chattanooga.