ETFs and Mutual Funds – what’s the difference?
Mutual Funds, in the simplest terms, are traditional actively managed funds of stocks usually. There are also funds that specialize in other things such as bonds, indexes, etc, but the average mutual fund is managed by a group of investment managers that choose a particular investment strategy (i.e. long term growth) and buy and sell stocks within that fund, attempting to keep the strategy in place at all times. Index funds are rarely managed by actual people, normally automatically rebalanced by computer models. Normally, index funds are “cheaper” than regular stock funds because of the active human management of the stock mutual funds. The expense behind the mutual fund is two-fold normally – the expense ratio and the load. The expense ratio is a measure of what it costs an investment company to operate a mutual fund. An expense ratio is determined through an annual calculation, where a fund’s operating expenses are divided by the average dollar value of its assets under management. Operating expenses are taken out of a fund’s assets and lower the return to a fund’s investors (Source: investopedia.com). Mutual funds are started with a load of cash and a management team.
ETFs on the other hand, start with an idea, such as tracking an index (i.e. S&P 500) and start with stocks instead of money. A great explanation of this at the Motley Fool: Major investing institutions like Fidelity Investments or the Vanguard Group already control billions of shares. To create an ETF, they simply peel a few million shares off the top of the pile, putting together a basket of stocks to represent the appropriate index, say, the Nasdaq composite or the TBOPP index we made up for the kick-off article. They deposit the shares with a holder and receive a number of creation units in return. (In effect they’re trading stocks for creation units, or buying their way into the fund using equities instead of money.)
So, what gives? What the heck is the actual difference of buying and selling these investment vehicles? Well, with mutual funds you (your broker) essentially orders shares and purchases at the Net Asset Value (NAV) at the end-of-day price. ETFs on the other hand, are bought and sold at any time of the day. This makes ETFs much easier to buy and sell, from a liquidation standpoint. Also, many mutual funds have minimum purchase amounts (i.e. minimum purchase amount of $5,000) as opposed to ETFs which you could buy 1 share if you so desired (however not optimal because of the commission as a percent of total investment that you would have to pay to your brokerage firm.
Mutual funds and ETFs have similar tax implications, in that you must pay taxes on your gains unless you purchase some sort of tax sheltered fund or ETF.
Some of the most actively traded ETFs, according to Etrade:
POWERSHARES QQQ TRUST UNIT SER 1
About the Author: Mike is the founder of this site, www.mikefanelli.com He has extensive professional experience in accounting and financial analysis, and is currently a licensed CPA in the state of North Carolina.
