Those of us who work in personal finance sometimes forget that our jargon is not fully understood by others. Just like when my son’s teachers explain his test scores using a ton of alphabet soup assuming I can put this information into some sort of parenting use, when really, I don’t get it at all.
So, here is a quick reminder of the difference between mutual funds and Exchange Traded Funds (ETFs) as told as a lightning-fast history lesson.
Trading stocks (ownership shares in a company) began in 1611 in Amsterdam. As time goes on, someone realized that individuals with lower amounts to invest could be brought into the fold by banding strangers’ money together and hiring a manager to decide when to buy and sell stocks. Voila, in 1924, thanks to the good folks at MFS Massachusetts Investors Trust, the modern mutual fund is born!
Mutual fund share prices are calculated once per day based on the closing price of the securities owned by the fund. This price is called the Net Asset Value (NAV). A mutual fund is obligated to buy back shares from its owners on demand. Shares of a mutual fund do not trade between owners, only between an owner and the mutual fund manager.
Fees charged by mutual funds can include front- or back-end sales charges (commissions paid to the person selling you the fund). Not all funds have this structure, and many can be bought as no-load (up front fees) through discount brokerage companies (Fidelity, Schwab, Vanguard).
All mutual funds have an annual expense ratio. This is an amount that is taken out of the fund’s NAV (a tiny bit each trading day) to pay the costs of running the fund. Expense ratios can vary widely based on the type of management (passive or active), type of investment (international small company vs US Treasury bonds), and a host of other factors.
Fast forward to the Great Recession. We are reeling from the housing market collapse, large financial institutions are going broke due to risky trading, and people are losing their jobs and homes. What the world really needs is a whole new way to invest in the stock market, right?
Well, somebody thought so, and around 2007 the first Exchange Traded Funds are introduced. These products are a basket or stocks or bonds that are based on an existing index (S&P 500 or Nasdaq). Sounds like an index mutual fund, right?
Close! Focus on the “traded” part of ETF. These shares trade during stock market hours between owners of shares. They trade all day, not just at the closing price of the underlying stocks. The share price is determined in part by the values of the stocks, but there is a second layer in ETF trading. What is your fellow ETF buyer willing to pay for your shares if you want to get out of the investment? That could lead to more volatile pricing than just a regular mutual fund.
There was the idea that ETFs are naturally less expensive than comparable mutual funds. This is not always the case, so pay attention to the expense ratios if you are choosing between products. Also, ETFs have stock trading transaction fees, as if you were trading Amazon or Apple stock.
Which is better? It depends on your needs. If you want to track a set list (index) representing a certain area of the market, an index mutual fund or ETF will both do the trick. If you want to actively trade your shares during the day or write options contracts against them, and ETF is better. A mutual fund may be better suited to a buy and hold investor.
There are other factors that go into whether I recommend mutual funds or ETFs. My suggested portfolios usually have a combination of both. Talk to your financial advisor about which product or what combo is best for you.