See also the 7 Questions to Ask When Buying a Mutual Fund
Let’s take a closer look.
- Open ended funds
Most mutual funds are open-ended funds. An open-ended fund issues more shares the more investors purchase the fund. Essentially there is no limit to the number of shares the fund can issue. Because there is a limitless supply of shares, the value of the investors’ shares is not affected by the number of shares.
- Close ended funds
In contrast to an open-ended fund, close-ended funds issue a limited number of shares available to the public. As such, the value of the fund is determined by the demand for the fund’s shares. The NAV, or net asset value, of the fund can be higher or lower than what the underlying value of the shares is worth.
ETFs on the other hand have three different types:
- Exchange-Traded Unit Investment
Securities are allowed and derivatives may be used in the fund; dividends are reinvested every quarter and paid out to shareholders in cash.
- Exchange-Traded Open-End Index Mutual Fund
Investments are limited in a single issue to 25% or less, and there are additional weighting limits for diversified and non-diversified funds.
- Exchange-Traded Grantor Trust
This is similar to a close-ended fund in that its configuration does not change despite the number of investors. Unlike closed-ended mutual funds and ETFs, the investor owns the underlying shares in the companies the ETF is invested in; dividends are paid out to shareholders directly.
To learn more about ETFs, check out ETFs 101: What is an ETF by Tom Lydon.
Trading and Liquidity
With mutual funds, before a purchase can be made the net asset value must be calculated, which occurs at end of day. However, mutual funds settle after their trade date faster. Mutual funds take one day to settle, while ETFs take three days after the trade date to settle. Overall, ETFs have more trading flexibility, but the longer settlement date is something to take into consideration. Another aspect to take into consideration is that an ETF doesn’t require a minimum initial investment like many mutual funds require.
In regards to liquidity, ETFs can vary in how liquid they are. Broad-based index ETFs have more trading liquidity than narrow ETF categories like country-specific products. The more thinly traded the ETF, the higher the spread between the bid and ask price. When there is little interest and low trading volumes, the spread increases and the investor may have to pay a price premium to own it. Mutual funds, on the other hand, can be bought or sold without worrying about a spread or how liquid the market is, but again, it is only bought or sold at the end of day.
When purchasing or selling a mutual fund or ETF there can be trading commissions as well. Many mutual funds can be found without loads, also known as commissions, while ETFs can have trading commissions that can cost per trade unless a no-commission ETF is used.
See also How Mutual Funds Are Taxed
With mutual funds, a fund manager can buy or sell securities at any given point in time to rebalance the fund, or in the case of a closed-end fund, to redeem an investor’s shares. The tax consequences are such that the investor will owe tax on any gains from these sales.
Why Mutual Funds Instead of ETFs?
Be sure to see The Cheapest Mutual Funds for Every Investment Objective
Mutual funds can also adopt an active investment management style that tries to beat the market index rather than match it. This would appeal to the more risky investor appetites. Further, mutual funds can adopt unique strategies that investors may find valuable.
Lastly, if an investor is making multiple investments with small amounts, the trading commissions on ETFs can add up per trade, whereas a mutual fund with no front or back load is essentially free to purchase up front. Either investment vehicle has the management expense associated with it.