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Mutual Funds vs. Exchange Traded Funds the Basics, Explained

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Everyone knows what mutual funds are, right? They have been around for eons, in the US since the 1920’s. But can you identify the differences between an open end and a closed end fund? They are both mutual funds, right? Actually, wrong! How about between a closed end fund and an exchange traded fund? They are, after all, both sold at market value instead of net asset value – so what is the difference? On top of that, where do hedge funds fit into the mix?

Don’t feel bad if you aren’t exactly clear on what the various fund types are. I knew programmers working at a mutual fund transfer agency that didn’t know either! I’m guessing that if you were to stop folks on the street, one out of three probably couldn’t tell you the differences.

Note: not specifically addressed here, but similar in concept are unit investment trusts. According to the SEC

 “A unit investment trust, commonly referred to as a “UIT,  is one of three basic types of investment company. The other two types are mutual funds and closed-end funds.’ (emphasis is mine).

This post won’t tell you which is a better investment, but it will attempt to refresh you on the differences between several fund types. But first, lets think about some of the similarities.

Similarities between fund types.

Mutual funds, closed-end funds and exchange traded funds are similar in that:

  • All are governed in the US by the Securities and Exchange Commission.
  • Mutual funds and ETFs can both be actively managed or indexed.
  • All can be bought and sold.
  • All provide a way for individual investors to diversify their investment money across multiple individual stocks and/or bonds.

 Open end mutual funds.

A mutual fund consists of multiple underlying individual stock or bond investments. Therefore, one share of a mutual fund represents a diverse mix of assets.

Mutual fund shares are sold by the fund (or through brokers) at net asset value. Net asset value is simply the sum of the value of each of the underlying stock and bond investments, divided by the number of outstanding shares of the fund.

That is why, when you buy or sell shares in an open ended mutual fund, you don’t know what the price is until late in the day. Before the price can be set, the market has to close, all of the prices of each stock or bond have to make their way to the fund’s computer systems, all of the trades and transactions within the fund for the day have to get processed (so the number of shares in the fund is known), and multiple verifications of the calculated NAV have to be done.

There are many entities involved in creating and running a mutual fund, all of them out to make money!

A fund sponsor starts the fund – which is actually kind of a shell company. The fund company has no employees but is run by several third parties, such as the fund adviser (or manager), an underwriter (who sells the shares in the fund), a transfer agent (who tracks and reports on all of the transactions happening in the fund), the custodian (who holds the assets of the fund company), a public accountant (to make sure the books are on the up and up), a board of directors (to oversee everything) and finally the shareholders (people who buy shares in the fund).

An open ended mutual fund can continuously make and sell new shares of the fund. With the new money, the fund manager will buy new underlying investments. Of course, to confuse things further, sometimes (not often) a fund manager will decide that this particular open fund should not sell shares to new investors, usually because the fund is so big that the manager can’t effectively manage it at that size.

Many types of mutual funds exist. Here are a few types of mutual funds:

  • Actively managed – the fund adviser attempts to maximize the earnings and share price.
  • Indexed – no fund adviser exists, instead the underlying investments mirror a market index of some sort – such as the S&P 500.
  • Money Market – historically seen as an alternate to a savings account, most funds try to keep the NAV at $1.
  • Stock funds – invest only in stocks of various types. Some stock funds specialize in value or growth, companies of a certain size (market capitalization), or stock in international compaines and etc.
  • Bond funds – invest only in bonds of various types. Some bond funds focus on corporate bonds, others on municipal bond issues, still others on global and etc.
  • Sector funds – invest in companies in a certain sector. Sectors are market divisions such as transportation or energy. All companies within the energy sector, for instance would have something to do with energy – oil companies, drilling companies and etc.
  • Target date funds – investment allocations change over time to meet the needs of the specified target date to redeem. For instance, a fund with a target date of 2040, would be allocated to more growth oriented investments now, but in 2030 would be allocated to more income producing investments.

 Closed end funds.

A closed end fund is not legally a mutual fund. “Mutual fund” is actually the common name applied to open-ended investment companies. A closed end fund is not an open-ended investment company. It has a finite number of shares that it holds and sells to individual investors at start up (Initial public offering). No more shares are ever created or sold. The start up shares can be traded on the open market.

Once the investment company raises the money to buy the initial underlying investments, the fund shares are configured into stock and listed on the exchanges.

The price of the closed end fund shares is set by the market and may not match the underlying value of the investments the fund holds.

Closed end funds are not as popular as mutual funds. They are typically a specialized investment and not quite as easy to redeem.

Closed end end fund managers do not select new or different underlying investments. The initial investments are kept until the end date of the fund.

Exchange Traded Funds.

Exchange traded funds (ETFs) can be created within either open ended investment companies or unit investment trusts.

The ETFs do not sell shares directly to individual investors. Shares are, instead, issued in very large blocks (like 50,000 shares) and sold as “creation units” to institutions. The institutions do not pay cash for the creation units. Instead, they trade a basket of securities that mirror the ETFs desired portfolio.

Then the institution splits up the creation unit and sells shares of it in the market to individual investors.

According to the SEC here is how individual investors sell their shares:

Investors who want to sell their ETF shares have two options: (1) they can sell individual shares to other investors on the secondary market, or (2) they can sell the Creation Units back to the ETF. In addition, ETFs generally redeem Creation Units by giving investors the securities that comprise the portfolio instead of cash. So, for example, an ETF invested in the stocks contained in the Dow Jones Industrial Average (DJIA) would give a redeeming shareholder the actual securities that constitute the DJIA instead of cash. Because of the limited redeemability of ETF shares, ETFs are not considered to be—and may not call themselves—mutual funds.”

Like mutual funds, there are both indexed and now a few actively managed ETFs. More kinds of ETFs are showing up each year.

Hedge Funds.

Hedge funds also pool investor money to diversify investments. These funds typically try to use leverage and other speculative methods to increase return, and thus may involve more risk. Unlike other funds discussed above, hedge funds are NOT regulated by nor do they report to the SEC. They usually offer shares privately and often only to accredited (read that rich) investors who supposedly know more about investing or can afford to lose the money.

What other similarities and differences between mutual funds, closed end funds, exchange traded funds and hedge funds have you encountered?  Which do you prefer as investment vehicles?

Resources: 

Investing

AUTHOR Derek

My name is Derek, and I have my Bachelors Degree in Finance from Grand Valley State University. After graduation, I was not able to find a job that fully utilized my degree, but I still had a passion for Finance! So, I decided to focus my passion in the stock market. I studied Cash Flows, Balance Sheets, and Income Statements, put some money into the market and saw a good return on my investment. As satisfying as this was, I still felt that something was missing. I have a passion for Finance, but I also have a passion for people. If you have a willingness to learn, I will continue to teach.

8 Comments

  1. Awesome information, I feel like I should start collecting these investing articles and printing them out as a resource guide for myself ;).

  2. I have some of my retirement in mutual funds, mostly index funds and some in ETF’s. Mostly I try to pick funds that have lower management costs. I have a high yield dividend fund currently that has a bit higher fee, but I’m trying to see if the dividend is worth it or if I should just stick with the index fund. That one might get changed when I do my annual evaluation.

  3. Such a great idea having a mutual fund for familys future needs.That is an awesome post. You have really layed out your points in great detail.

  4. I love to invest for long duration of time. As my knowledge ETF is good for short duration of time so I prefer MF. Mutual fund is very good to manage passively. So for my stock I would choose Mutual fund.


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