Financial Education

Conventional mutual funds pool the resources of many investors into a fund that is managed as one portfolio. Each shareholder in the fund is entitled to a pro-rata share of the assets. New purchases and sales add or subtract from the total portfolio value. For an Exchange Traded Fund (ETF), the shares issued merely represent the value of the securities in the fund. They typically cannot be exchanged for cash, but can be freely traded between investors. Purchases and sales do not affect the assets held by the fund.

Since a mutual fund is pooling accounts, it must account for each shareholder’s stake individually. This can become expensive if there are many small shareholders. By contrast, the shareholders in an ETF are not able to cash in the shares from the portfolio manager. Therefore, the manager need not account for each shareholder’s position. Shareholders wanting to cash in their position can sell the shares to someone who wants to buy them, with no impact on the portfolio holdings.

ETFs, however, must generally pay higher index license fees. This offsets some of the cost advantage gained by not having to account for positions at the shareholder level.

ETFs tend to have a tax advantage, because mutual fund buyers are buying into a pool of assets, many of which may have a taxable basis below the current market value. They are essentially buying into taxable gains. Since ETF shares can only be redeemed by a broker through an in-kind transaction, the shares with significant gains tend to be those redeemed in-kind, reducing the taxable basis for new shareholders.

Also because of the fact that most ETF trades are between shareholders (rather than between one shareholder and the fund) redemptions do not force the fund to sell shares, potentially impacting the other investors in the fund.

Update: This article was included in the Carnival of Financial Planning.

For more information, see all articles on: Asset Allocation, Investing in Stocks, Portfolio Management

See also:

Exchange Traded Funds (ETFs)

Market Timing by Mutual Funds

Asset Fire Sales in Equity Markets

What is the Difference Between a Hedge Fund and a Mutual Fund?

Open-End Mutual Funds