ETF Univ: Mutual Funds Or ETFs?

ETF UNIVERSITY

On one level, mutual funds and ETFs do the same thing, but they have key structural differences.

The biggest difference of course is that ETFs are “exchange traded.” That means you can buy and sell them intraday, like any other stock. By contrast, you can only buy or sell index funds once per day, after the close of trading. You do this by contacting the mutual fund company directly and telling them you want to acquire or redeem shares.

What does all that mean for investors? And how do you choose? Let’s examine the differences:

Positives Of ETFs
• Intraday Liquidity: You can buy and sell ETFs at any time during the trading day. If the market is falling apart, you can get out at 10 a.m. In a mutual fund, you would have to wait until after the close of trading … which could be a costly delay.

• Lower Costs: Although it’s not guaranteed, ETFs often have lower total expense ratios than competing mutual funds. The reason is simple: When you buy shares of a mutual fund directly from the mutual fund company, that company must handle a myriad of paperwork to record who you are, where you live and to send you documents. When you buy shares of an ETF, you do so through your brokerage account, and all the record keeping is done (and paid for) by your brokerage firm. Less paperwork equals lower costs, most of the time.

• Transparency: Holdings of most ETFs are disclosed on a regular, frequent basis, so investors know what they’re investing in and where their money is parked. Mutual funds, by contrast, only disclose their holdings quarterly, with a 30-day lag.

• Tax Efficiency: ETFs are almost always more tax efficient than mutual funds because of the benefits of their creation/redemption mechanism.

• Greater Flexibility: Because ETFs are traded like stocks, you can do things with them you can’t do with mutual funds, including writing options against them, shorting them and buying them on margin.

Cons Of ETFs
• Commissions: The beauty of intraday liquidity doesn’t come without costs: Typically, you pay a commission when you buy or sell any security, and ETFs are no different, which can make dollar cost averaging cost-prohibitive. There are an increasing number of commission-free ETF trading programs in place at firms like Charles Schwab, Etrade, Fidelity and TD Ameritrade. But check before you trade.

• Spreads: In addition to commissions, investors also pay the “spread” when buying or selling ETFs. The spread is the difference between the price you pay to acquire a security and the price at which you can sell it. The larger the spread—and for some ETFs, the spread can be quite large—the larger the cost. There’s no way to avoid this.

• Premiums and Discounts: When you buy or sell a mutual fund at the end of the day, you always transact exactly at its stated “net asset value” (NAV), so you always get a “fair” price. While mechanisms exist that keep ETF share prices in line with their fair value, those mechanisms aren’t perfect. At any given moment, an ETF might trade at a premium or a discount to its NAV. If you buy at a premium and sell at a discount, ouch … you’ve lost out.

• General Illiquidity: Not all ETFs are as tradable as you think. Some trade rarely, or only at wide spreads, which can make them hard to unload once you purchase them.

Conclusion
Usually, the choice comes down to which features you value most. Importantly, there’s no reason this must be an either/or question. Mutual funds can live side by side with ETFs in a portfolio perfectly happily.

SELECTED TERMS

Bid/Ask Spread
ETFs trade like single stocks, so bid/ask spreads are a part of daily life for an ETF. The spread is simply the difference between the price someone is willing to pay for an ETF (the bid) and the price someone is willing to sell that ETF for (the ask). The most important takeaway here is that the wider the spread, the more expensive it is to trade that ETF. That’s why we list the “average spread” for all ETFs in our fund pages (etf.com/ticker) along with other crucial data points such as expense ratio, assets under management and average daily volume. This metric should be part of your ETF due diligence if costs are important to you.

Creation/Redemption Mechanism
It’s how ETF shares are created and redeemed, in a process that’s unique to the ETF structure. When there’s demand for new shares of an ETF, an authorized participant buys the securities the ETF holds, and hands that basket of securities to the ETF issuer in exchange for ETF shares. This is known as an in-kind transaction—securities for shares. In the case of a redemption, this process works in reverse. The in-kind nature of the creation/redemption mechanism is crucial to how ETFs trade because it allows them to trade throughout the day in line with the value of their underlying holdings (their net asset value).

Custodian
In the ETF ecosystem, the custodian—often a large bank—is responsible for holding all the securities and cash for an ETF. That custody role is crucial to the day-to-day operations of a fund, even if it’s a largely overlooked role by most investors. Custodians hardly make headlines, and most investors don’t know who custodies the ETFs they own. But occasionally custodians are all the buzz, when companies involved with things like federally illegal marijuana find their way into ETF wrappers. Then suddenly, custody becomes a hot-button issue.

Market Maker
Also known as a liquidity provider, a market maker is someone who facilitates ETF trading, ensuring tight bid/ask spreads, depth and smooth trading throughout the day. Every ETF has a lead market maker, many of which are incentivized by exchanges to keep markets humming along.