Mutual funds and ETFs
Let’s refresh on what mutual funds are. A Mutual fund is a type of investment where more than one investor pools their money together to purchase securities. Most mutual funds have a minimum investment of between $500 and $5,000, but some don’t have a minimum at all. Even a relatively small investment provides exposure to as many as 100 different stocks contained within a given fund's portfolio.
Let’s refresh on what an ETF is. Exchange-traded funds are similar to mutual funds, but they trade throughout the day, on a stock exchange. In this way, they mirror the buy-and-sell behavior of stocks. This also means that their value can change drastically during the course of a trading day. This can include anything from emerging markets to commodities, individual business sectors such as biotechnology or agriculture, and more.
Now what’s the difference between the two?
Well, a key difference between a mutual fund and a stock is that ETFs can be purchased and traded throughout the day, while mutual funds can only be purchased at the end of a trading day after the net-asset value has been determined (net asset value represents fund’s per share market value). Mutual funds are also actively managed, while ETFs are passively managed. Actively managed funds deal with fund managers making decisions about allocating assets in a fund, while passively managed funds just track market/sector indicators.
Two types of mutual funds
More Mutual Funds
So, what exactly are you getting into with a mutual fund?
When you invest into a mutual fund, you’re investing into the performance of its portfolio or at least a part of the portfolio's value. These funds consist of a portfolio of stocks, bonds, or other securities. This is operated by ‘professional money managers’ who allocate the fund's assets and attempt to produce income to the fund’s investors. Everything is organized into different categories: the kinds of securities to invest in, their investment objectives, and the type of returns they seek.
What benefits do ETFs have that mutual funds don’t?
ETFs tend to be more liquid and cost-effective than mutual funds as there is a lower turnover and fewer capital gains involved because ETFs are bought and sold at different prices throughout the day while mutual funds are sold once a day at one price.
There is something known as a creation and redemption process for ETF shares, which is opposite of that of mutual shares.
Let’s elaborate on that…
When investors invest in mutual funds, they send cash to the fund company and use cash to purchase securities, so when they redeem their shares, they receive cash back.
Now, ETFs, on the other hand, do not involve any cash.
The process includes an Etf manager (known as a sponsor) who files a plan with the US Securities and Exchange Commission. The plan must be approved by the sponsor who forms an agreement with an authorized participant (usually a market maker, specialist, or institutional investor). The authorized participant can also be the same as the sponsor.
Now what even is this authorized participant?
Well, good question! The authorized participant acquires stock shares and places them in a trust. These form the so-called ETF creation units, which are just bundles of stocks which vary from 10,000-600,00 shares (although, 50,000 is what’s commonly known as one creation unit of an ETF.
The trust, then, provides shares of the ETF, which are just legal claims on shares held in the trust. The ETFs represent the tiny slivers of the creation units. It’s important to remember this transaction is known as an in-kind trade (securities trade for securities), so there’s no tax implications either. After these authorized participants receive their stock shares, they are then to sold to the public on the open market (just like stock shares)
And that’s the creation process of ETFs! Now, this is a creation and redemption process, so you might be wondering how you redeem this ETF?
Well for one, they can sell these shares on the open market (most popular option amongst investors)
Second, they can gather enough shares of the ETF to form the creation unit and then exchange the creation unit for underlying securities (option only available to institutional investors due to the large number of shares required). These investors redeem their shares, destroying the creation unit, and the securities can be turned over to the redeemer.
*Beauty of this option is no tax implications
What is the significance of tax implications?
Well, in mutual funds, when investors redeem shares from a fund, the shareholders are affected by the tax burden. This is because to redeem the shares, the mutual fund may have to sell the securities that it holds, realizing the capital gain, which is subject to tax.
ETFs minimize the scenario by paying large redemptions with stock shares. When such redemptions are made, the shares with the lowest cost basis in the trust are given to the redeemer.
They also require you to pay out all dividends and capital funds on a yearly basis. Now, what this means is that even if a portfolio has lost value, there’s tax liability on capital gains because of this requirement.
Etfs, on the other hand, minimize this scenario, because they pay large redemptions with stock shares. When these redemptions are made, the shares with the lowest cost basis (original price of asset) are given to the redeemer.
This increases the cost basis of the ETF’s overall holdings, minimizing its capital gains. It doesn’t matter to the redeemer that the shares it receives have the lowest cost basis because the redeemer’s tax liability is based on the purchase price that it paid for the ETF shares, not the fund’s cost basis.
When the redeemer sells the stock shares on the open market, any gain or loss incurred has no impact on the ETF. This results in ETFs being much less riskier, as opposed to mutual funds in this manner.
Speaking of risk, we brought up diversification earlier.
Well, what exactly is diversification?
Diversification is a risk management strategy that deals with a wide variety of investments within a portfolio in an attempt to reduce profile risk. The rationale behind this technique is that a portfolio constructed of these different assets will, on average, yield higher long-term returns and lower the risk of an individual holding or security.
Its goal is to smooth out unsystematic risk vents in a portfolio, so the positive performance of some investments will neutralize the negative performance of others.
(Can also be achieved by purchasing investments in different countries, industries, sizes of companies, or term lengths for income-generating investments)
Quality of diversification in a portfolio is most often measured by analyzing the correlation coefficient of pairs of assets.
