ETFs, exchange traded funds, and mutual funds are both investor packages that manage investors’ money. They are managed by professionals for the benefit of the investors, who own shares in them. This basic investor guide will highlight how they are similar, and how they differ from each other.
Both ETF’s and mutual funds are baskets of investments. When you own shares in them, you own a small part of the basket, which consists of a collection (portfolio) of investments. However, they work differently, and you invest in them differently.
Mutual funds are unique because they are open-ended. They have no fixed number of shares, and their shares are not traded on exchanges. When investors buy shares, their money goes into the fund and is added to the investor pool of assets to be managed by the mutual fund. New shares are issued to the individual investor, and the pool of assets in the fund gets larger.
When investors want to liquidate (sell) shares, the transaction again goes through the mutual fund company. In the process assets are taken from the pool of assets to pay the individual who is exchanging his shares for cash. Those shares then no longer exist, and the collective pool of assets becomes smaller.
Mutual funds belong to a mutual fund family, and offer investors numerous features. For example, you can switch from one fund to another within the family, or you can purchase shares on a monthly plan. If, however, you want to buy or sell shares and need a quick transaction…they were not designed to do that.
ETFs are actually index funds that are managed to track an index. They trade like stocks on major exchanges. For example, (SPY) tracks the S&P 500 stock index. There are also mutual funds that are index funds as well, including S&P 500 index funds that track the S&P 500 index.
The difference is that ETFs are not open-ended. The number of shares outstanding is fixed…similar to GE, Microsoft and other corporations whose stocks trade on major exchanges. Once shares are initially sold, the corporation (or the fund) has its money for operations, or to manage in the case of an ETF. Then these shares trade in the market.
To keep our investor guide simple, when you or I buy or sell ETF shares or shares of GE etc., we are simply buying or selling existing shares as they trade in the market. We do this through the services of a brokerage firm, and can make transactions throughout the business day. With an ETF, your order to buy or sell is executed within seconds.
ETFs have become very popular with active investors. Some track the major market indexes, others track industries or sectors. For example, if you want to invest in oil stocks, gold stocks, or real estate stocks, there are ETFs that track those sectors. If you are interested in bonds, there are bond ETFs that track bond indexes.
As a basic investor guide, if you are a long-term investor who wants features and flexibility in your investment package, stick with mutual funds. If you want to play the market, you need the instant liquidity of ETFs.
A retired financial planner, James Leitz has an MBA (finance) and 35 years of investing experience. For 20 years he advised individual investors, working directly with them helping them to reach their financial goals.