ETF stands for exchange-traded fund, and you purchase them as you would stock -- unlike open-end mutual funds, that you must purchase from the mutual fund company directly, through a sales representative. However, there are also closed-end mutual funds, which also trade like stock. You need to understand each type of mutual fund, and then compare both to the ETFs, in order to understand their differences.
If you own a mutual fund, most likely it is an open-end fund. An open-end mutual fund company continuously produces new shares. The distinguishing factor here is the creation of new shares to accommodate new investors, and the redemption of shares through the company. The open-end mutual fund company calculates the net asset value (NAV) at the close of the market day, regardless of when you buy or sell the shares, and this dictates the redemption and purchase price of the shares.
Just like ETFs, closed-end funds trade on the stock market. Unlike open-end funds, the value of the share doesn't depend on the underlying value of the investments it holds. Rather, it depends on how much the market investors are willing to pay, just like stocks. The price you pay is the price at the time of purchase, just as the sell price is.
Exchange traded funds work just like closed-end mutual funds, but with one big difference. The difference has to do with institutional investors. The larger investors have the ability to trade the shares for the underlying investments without a taxable gain. The IRS considers it a "like and kind" trade. Smaller investors also receive a benefit from this.
If the same large investor has to sell open-end mutual funds rather than trade them, it triggers a taxable incident for every investor, since the company sells underlying investments to secure funds. In a closed-end fund, a large sale makes the price of the fund drop.
Benefits of Open-End Funds
Redemption is easy in an open-end fund, but you don't get the opportunity to time the sell to match the daily market peaks and valleys. If you wish to change your investment, you can simply exchange the funds for another mutual fund in the family, without incurring a new sales charge.
ETFs and Closed-End Funds
Since these both sell on the market, you don't have to depend on the calculation of NAV at the close of the day, and can sell them during the day at a peak price. Unlike open-end mutual funds, you sell both in the stock market, not redeem them through the mutual fund company, which means they have to keep a large amount of cash for share redemption. This creates "cash drag" for the open-end fund, and lowers the return in a rising market, since the funds aren't available to invest.
However, since large institutions don't affect the price of the shares, ETFs tend to mirror the price of the underlying shares more closely. You do not automatically have a purchaser with either, and must pay brokerage fees on both the purchase and sale of the shares.
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