Choose one: How would you best describe exchange-traded funds?
A. Traditional
B. Alternative
C. Conservative
D. Aggressive
E. All of the above
As you might suspect, E is correct. Exchange-traded funds — or ETFs, as they’re known — come in multiple varieties to match differing investor preferences and needs. Let’s take a quick look at how ETFs compare with traditional mutual funds, and then we’ll look at the types of ETFs and how they might fit in your portfolio.
ETFs vs. traditional mutual funds
At their core, ETFs and traditional mutual funds serve the same purpose: They allow savers to pool their money together to invest more efficiently and effectively. Investors buy shares in an ETF or a traditional mutual fund, which hires a professional investment manager to put the money to work in the markets.
ETFs and traditional mutual funds also both provide daily liquidity, so it’s easy for investors in either vehicle to convert their holdings to cash.
Where they differ is in their mechanism for accepting investments and providing liquidity. Investors in a traditional mutual fund arrange transactions directly with the fund. On any business day, investors can indicate that they would like to buy or sell fund shares. Their transactions are completed after the New York Stock Exchange closes at 4 p.m. at a share price determined by the value of the fund’s portfolio holdings at that time.
In contrast, ETF investors buy and sell shares of the fund on the stock market, while designated parties — called “authorized participants” — make sure that the number of the ETF’s shares trading in the open market matches investor demand at any given time.
This indirect approach to managing flows in and out of an ETF has advantages and disadvantages. On the plus side, investors can buy and sell ETF shares whenever the stock market is open; they don’t have to wait until the end of the business day, as they do with traditional mutual funds.
On the flip side, the price an investor pays for an ETF share in the market may not exactly match the value of the fund’s underlying assets, as it does with a traditional mutual fund. The market price may be higher or lower than the ETF’s “net asset value,” sometimes by a substantial amount.
Trading on an exchange can entail additional costs; investors usually must pay a brokerage commission when transacting in ETF shares, though a few brokerage firms waive these commissions for investments in ETFs that they sponsor. By contrast, traditional mutual funds don’t charge transaction fees, except possibly when investors are buying and selling within a very short time. (Investors buying traditional mutual funds through financial advisers may pay separate fees for their assistance, though, in the forms of loads or other marketing charges.)
In addition, an ETF’s indirect mechanism for transactions limits the types of portfolio strategies an ETF can employ. That’s because authorized participants need complete information about an ETF’s investments -- information that is readily available about market indexes but not about actively managed portfolios.
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