The three basic forms of investment companies consist of closed-end companies, unit investment trusts and open-end companies or mutual funds. Exchange traded funds fall somewhere between the unit investment trust and the open-end fund, with some characteristics of a closed-end company. Understanding the differences between these two investments can confuse even the most avid investor.
Mutual Fund Basics
As an investment company, mutual funds or open-end companies offer investors the ability to invest in a diverse portfolio of securities. If your company offers a 401k retirement plan, odds are good that the plan has numerous mutual funds you can choose as investment options. The classic characteristics of a mutual fund include allowing investors to redeem purchased shares or buy shares directly from the mutual fund or a registered broker/dealer of the fund. Also, net-asset value determines mutual fund prices.
Exchange traded funds legally operate as open-end companies or unit investment trusts. Like a mutual fund, an ETF gives the investor a low-cost way to participate in a broad sector of the market with simple trading transactions. Although an ETF can get classified as an open-end company, it differs from the traditional mutual fund in a number of ways.
How They Differ
Mutual funds sell directly to the individual investor, whereas ETFs sell in large blocks of units called creation units. Once all the creation units are sold, investors have two ways to sell their units -- they can split them up and sell them or they can resell them to the ETF. Mutual fund owners can redeem shares at anytime by selling them back to the fund, which then has seven days to forward any proceeds to the investor. Because ETFs redeem creation units by giving the investor the actual shares of stock instead of cash, they cannot call themselves a mutual fund.
Trades Like Stock
So, what’s the deal with creation units? You own ETFs and you never purchased large blocks of units, right? Well, that’s because large institutional investors buy creation units. Before you even get the chance to buy individual units of an ETF, large blocks of units get bought and split up into individual units. These individual units trade in the secondary market on an exchange such as the NYSE or NASDAQ, allowing investors to sell them short and buy them on margin -- which can never happen with mutual fund shares.
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