Canto 6

What is the difference between a mutual fund and an ETF?

Both mutual funds and exchange traded funds (ETFs) are ways to diversify without investing a huge amount of money. They both allow you to invest in a fund that owns a variety of different stocks or bonds (or whatever). They work somewhat differently.

What is a mutual fund?

A mutual fund is a professionally managed investment arrangement that pools the money of many investors to buy securities. Usually it is organized by a for-profit company that manages a family of different mutual funds. In Canada a lot of them are organized and managed by the investment arms of the major banks, but there are plenty that are offered by other companies, too. If you invest in a mutual fund, you are usually buying shares directly from the mutual fund company - perhaps with the help of a broker or investment advisor. If you sell your investment, you sell your shares back to the company. If more money is coming in than going out, the mutual fund company goes out and buys more securities with the money. If more shares are being sold than purchased, the company has to sell securities. A mutual fund is supposed to have a stated set of objectives that you can read about in its prospectus. It might say, for example, that it invests in the stocks of large Canadian companies. Or it might say that it invests in long-term corporate bonds. This means that when you buy shares and the mutual fund company has to go out and buy some securities, it's fairly predictable what they will go out and buy.

Most mutual funds are called "open-ended" funds, which means that if a new investor wants to buy some shares, the company basically makes new shares for them. Then they go buy some securities with the money. If more people are selling shares than buying them, the shares are basically popping out of existence. The price of the shares in an open-ended fund is set at the end of each trading day by adding up the market value of all the securities it owns and dividing by the number of shares people own. There are also closed-end funds and unit investment trusts. In both cases, the number of shares is fixed at the beginning when the fund is created. I've never used either of those, so I don't know much about them. The price of shares in a closed-end fund is based on how much people are willing to pay for them in a market where they trade (because there are no new ones being issued, the only way you can get them is to buy them from another investor).

The investors in a mutual fund company have to pay a variety of expenses associated with the fund. These can include sales charges, management fees, transaction fees, and fees associated with tax reporting (for retirement accounts and such). I'm not going to talk about those here, because I'm going to devote a whole note to investment fees. Stay tuned for a real rant on that one.

Mutual funds come in several main varieties:

Some hybrid funds are aimed at a particular type of objective. For example, if you're a young investor and you want to put money in just one fund, you could buy one that puts most of its money in equities but also holds some bonds.

To buy mutual funds, you can work through a broker or an investment advisor, but in some cases you can also buy them directly from the company that manages them. In our US investments, we bought all the mutual funds we own directly from the mutual fund companies with no sales agent in between. In our Canadian investments, we are currently buying them through an online brokerage.

What is an ETF?

An exchange-traded fund is an investment fund that is traded on a stock exchange, just like any other kind of stock. Just like mutual funds, they own a variety of securities. The price of their shares is not fixed to the value of the securities they own, but is usually pretty close to it. The reason is that there are "authorized participants" who can, at any time, buy or sell a huge block of ETF shares in exchange for an equivalent basket of the securities it is supposed to own. If one of these big brokers notices that the ETF share value has risen above the value of the basket of securities it is supposed to own, they go, "Hey, I could make a few thousand dollars if I traded in these securities and got some ETF shares instead!" So they do, and then they go out into the market and start flogging the ETF shares they bought. That pushes the price of the ETF shares down a bit and brings it back in line with the value of the securities it owns. Same thing happens in reverse if the ETF share value dips too low.

Most ETFs have a simple investment objective, such as to track an index of stocks or bonds. An index is a representative basket of securities that represents how a particular market is doing. For example, the S&P 500 Index is a collection of the 500 largest companies that trade on the two major US stock exchanges. It is published by an independent organization called S&P Dow Jones Indices. If you buy an ETF that is supposed to follow the S&P 500 Index, it will very predictably own a mixture of stocks that mimics the S&P 500 Index of stocks. One of the advantages of this is that it requires very little thought. The authorized participants just swap in or out a basket of S&P 500 Index stocks in exchange for ETF shares, and no one has to spend a lot of time "managing" which shares to own. That means ETFs have very low management fees. I will talk about that in my rant on investment fees. There are some actively managed ETFs now, too, but most of them are still based on an index.

ETFs come in some of the same varieties as mutual funds, but there don't seem to be money market ones and there are some additional types:

When you buy shares in an ETF, you pretty much have to buy them through a broker, unless you happen to be a gigantic brokerage firm that can become an authorized dealer. You are buying them from some other investor who wants to sell. When you sell them, you sell them through a broker, and again you are selling them to someone else who wants to buy. Generally this means it is easiest to buy and sell them in blocks of at least 100 shares at a time.

Which one should you get?

I believe investors should really watch the investment fees they pay, so in Canada I think ETFs are very attractive. I think often mutual funds are easier to buy, because you can walk into your bank branch and someone will set up a mutual fund account for you and help you put money in it. You have to buy ETFs through a broker, and some people find that harder.

In the US, the advantages of ETFs are less clearcut, because there are some mutual fund companies with extremely low costs, particularly for their mutual funds that follow an index.


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