Following is the first in a two-part series on mutual and exchange-traded funds.
You’re probably familiar with mutual funds. They are arguably the most common type of investment choice for 401(k) and other retirement accounts.
Exchange-traded funds (ETFs), by contrast, have only been around since the early 1990s and have yet to find their way onto many retirement plan menus. But they are widely available for brokerage accounts and since 2008 have experienced explosive growth. You may be wondering what the difference is between the two types of funds and which makes a better investment.
ETFs, like traditional mutual funds, represent a basket of assets such as stocks or bonds. Unlike mutual funds, investors cannot buy ETF shares directly from the investment companies that offer them. Instead, investors must buy ETFs from other investors, just like stocks. That has two implications: (1) You can buy ETFs anytime during the trading day, unlike mutual funds, which can only be purchased at the end of the day after their net asset values have been calculated, and (2) during periods of high demand, the prices of ETFs can exceed the net asset value of their underlying assets.
Because buyers generally do not want to pay more than an ETF is worth, something is needed to keep the price close to the ETF’s net asset value. The solution is to allow certain financial institutions, known as authorized participants, the ability to purchase and redeem blocks of ETF shares, called creation units, directly from the ETF company. This approach gives ETFs an arbitrage mechanism that tends to minimize the potential deviation between the market price and the net asset value of the ETF’s shares.
If there is strong investor demand for an ETF, its share price will (temporarily) rise above its net asset value per share, giving authorized participants an incentive to purchase additional creation units from the ETF and sell the component ETF shares in the open market. The additional supply of ETF shares reduces the market price per share, generally eliminating the premium over net asset value. A similar process applies when there is weak demand for an ETF, and its shares trade at a discount from net asset value.
Creation-unit purchases and redemptions are in kind – meaning that the underlying assets are traded back and forth rather than bought and sold – allowing the authorized participants to swap out low-basis shares for high-basis shares without having to pay tax. As a result, ETF proponents argue that ETFs are more tax efficient than mutual funds, which cannot be traded like that.
Another professed benefit of ETFs is the lower expense ratio – the annual costs fund holders have to pay to the fund companies – compared with mutual funds. While true in the aggregate, this is really due to the fact that the majority of ETFs are passively managed and based on indices created and updated by various other financial institutions. There are numerous examples of mutual funds in certain asset classes that are less expensive than their ETF counterparts.
Craig Israelsen, associate professor at Utah Valley University, recently attempted to quantify the performance difference between mutual funds and ETFs. In part 2 of the series, I’ll share his findings.