The Main Goals: Understand what an Exchange-Traded Fund is; Comprehend how they are different from Mutual Fund; Find out about trading cost transparency, tax efficiency, and expense ratios; and learn what an index is.
This first lesson covers:
- Characteristics of an Exchange-Traded Fund (ETF)
- How ETFs differ from mutual funds
- Types of ETFs
- Defining an index
What is an Exchange Traded Fund (ETF)?
An ETF is a 1940 Act exchange-traded investment wrapper that tracks a basket of securities very similar to a mutual fund, but it is traded on an exchange. While most ETFs are designed to replicate and track an index, some are not tracking an index and are actively managed. ETF investors do not interact directly with the ETF exchange company. They trade ETF shares on an exchange.
How does an ETF differ from a mutual fund?
Buying and selling ETFs
- ETFs are traded on an exchange intraday
- Mutual funds are traded through the mutual fund company
- Mutual funds are traded once a day at Net Asset Value (NAV)
- ETF holdings are published on a daily basis, and they are transparent at all times
- Mutual fund holdings are published on a quarterly basis, generally on a 30-day lag
- The minimum investment for an ETF is one share
- The price of the ETF = the minimum investment
- Mutual funds tend to have higher minimums depending on the share class
Transparency of trading costs
- ETF trading costs are borne by each individual investor
- The cost is transparent through the bid-ask spread that you see on exchange
- Costs of trading for a mutual fund are borne by all investors as the trading costs are wrapped into the NAV each day
- ETFs are more tax efficient because of the technology of the creation redemption mechanism
- Mutual funds are less tax efficient because trading is done inside the fund by a portfolio manager
- ETFs generally tend to be less expensive vehicles
- Mutual funds typically have higher expense ratios and vary depending on share class liquidity
- ETFs have daily liquidity and they have intraday liquidity
- As long as the exchange is open, you can trade in and out of the fund
- With mutual funds you can get in and out one time a day at NAV
What is an index?
An index is a hypothetical portfolio of investment holdings representing a segment of the financial markets. They are typically a benchmark index such as the:
Russell 2000 Small-Cap
You cannot invest directly into an index. You must use some other sort of vehicle that tracks that index, and that is initially how ETFs were designed. Today, most ETFs still track an index.
The difference between the ETF and the index in a perfect world is called “tracking error,” and the tracking error difference between the return of the index and the ETF will be that fund’s expense ratio.
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