A mutual fund is an open-end fund operated by an investment company that raises money from people and invests it in stocks, bonds, money market instruments or other assets. Each investor in the fund owns shares that represent a part of these holdings.
Mutual funds raise money by selling shares of the fund to the public, like any other type of company that sells its stock. The pool of funds collected from investors is used to buy various investment vehicles. The portfolio of the fund is professionally managed in order to achieve gains. The net asset value (NAV) of the fund is calculated every day depending on the daily performance of the securities held. This determines the price of a share that is changed once a day. For most mutual funds, shareholders can sell their shares at any time. Purchases and sales take place directly between investors and the fund.
Mutual funds often require a minimum investment.
ETFs (Exchange Traded Funds) are securities that track an index, a commodity or a basket of assets like an index fund, but they trade like a stock on an exchange. An index fund is a collection of stocks that represent a particular region, country, sector, or asset class. It is also possible to index silver, gold, oil, and commodities. ETFs always bundle together the securities that are in an index, unlike mutual funds, they never track actively managed mutual fund portfolios.
The price of a share fluctuates continuously throughout the day Since ETFs are traded on stock exchanges, they can be bought and sold at any time during the day. Investors can do just about anything with an ETF that they can do with a normal stock, for example short selling. ETFs provide the ability to buy on margin as well. As ETFs track indexes they have low operating and transaction costs. There are no investment minimums required to purchase an ETF.
On the other hand, investors need a broker in order to purchase ETFs, so the transactions incur a broker fee.
Benefits of both kinds of instruments include diversification, choice, liquidity, and convenience. Both give small investors access to diversified portfolios, which would be impossible to create with a small amount of money. Each shareholder participates proportionally in the gain or loss of the fund.
Mutual funds and ETFs differ in structure, expenses and the ways they trade.
Structure of the funds:
In case of mutual funds, the more money that comes in, the more shares are created. An ETF is created in large lots by institutional investors that already control billions of shares and put together a basket of securities to represent the appropriate index.
Traditional mutual funds are traded at the end of the day when the net asset value is determined. ETFs trade like stocks, all day long and are priced continually by the market. Thus ETFs offer greater flexibility. The investor can tell the broker to purchase ETF shares only at a pre-defined price.
Mutual funds often require a minimum amount, ETFs have no minimums. You can purchase as few shares as you like.
Mutual funds usually do not charge transaction fees. Brokerages charge commissions for ETF purchases. A few years ago this would have been a disadvantage, but nowadays there are low-cost brokerages that enable small, frequent purchases of ETF shares. You have to take into consideration that frequent trading of ETFs increases commissions, offsetting the benefits gained from lower fees.
Due to the passive nature of indexed strategies, the internal expenses of ETFs are lower than those of mutual funds.
Advanced trading possibilities:
ETFs offer advanced trading possibilities such as options that give investors the right to buy or sell shares of the ETF at some point in the future for some specific price.
As ETFs may trade at a price other than the true NAV, they provide the opportunity for arbitrage. ETFs also provide shorting possibility, you can bet against the index, and earn money if it drops. This is important to traders, but of little interest to long-term investors.
Mutual funds often provide automatic dividend reinvestment. With dividend-paying ETFs, the dividend is paid to your brokerage account, just like the dividend on a regular stock. If you want to reinvest it, you have to make another purchase.
ETFs are more tax-efficient than mutual funds. If an investor redeems a certain amount from a traditional fund, the fund has to sell part of the stock to be able to pay cash for the investor. Taxes for the turnover are paid within the fund and the cost of this is borne by the fund holders. If an ETF shareholder sells his shares, the ETF doesn't sell any stock, it offers investors in-kind redemptions, as for every ETF seller, there's a buyer.
Both ETFs and mutual funds are viable choices for investors, but with so many available on the market, it is important for investors to familiarize themselves with the differences between products to ensure they are making appropriate investment decisions.