An Exchange Traded Fund (or ETF) is an investment fund, similar to a Mutual Fund, but one that can be bought and sold during the trading day on a stock exchange. ETFs can track stock indexes, stock sectors, commodities, bonds or specific investments, such as art or a specific strategy. Until recently, most ETFs were passively managed to replicate the returns on a stock index or of a group of stocks before fees. Passively managed funds have a low turnover in stocks and only change when there is a change to the underlying asset. However, recently some ETFs have experimented with actively managed funds to replicate certain styles, such as seasonality or low volatility. An actively managed fund is subject to all the same risks of a passively managed fund with the additional risk of manager risk, the risk the manager underperforms his benchmark. Actively managed ETFs have had varying successes at this early stage of development and will likely continue to develop.
Mutual Funds are redeemed or created at the end of a day, after the close of market. The Net Asset Value (NAV) is calculated and shares are redeemed or sold at that valuation. A Mutual Fund may require selling assets to pay for redemptions or investing a large infusion of cash due to a sale of units. This can create tax events for holders of the Mutual Fund without buying or selling any shares.
ETFs trade during the day, requiring demand and supply to balance without affecting the ability to track the underlying asset. ETF experts create and eliminate shares during the day to create this balance. Without going too far into the machinations of the process, this does describe how much more complicated ETFs are than Mutual Funds, and emphasizes why investors interested in ETF insights should read the prospectus.
ETF’s have some advantages over Mutual Funds. ETFs are a newer product developed in Canada in 1990, and were designed to improve upon the deficiencies of passively managed Mutual Funds. ETFs are usually a lower cost investment, with lower Management Expense Ratios (MERs) and requires a commission, like purchasing a stock through a broker, instead of an upfront or deferred sales cost.
ETFs are more liquid than Mutual Funds. Mutual Funds are a fairly liquid investment instrument but can only be redeemed after the close of the stock exchanges so that the Net Asset Value (NAV) can be calculated. This is unlike ETFs, which trade like stocks and the NAV is calculated continuously. Some Mutual Funds also have restrictions on when they can be redeemed or only after a minimum period, where as an ETF can be bought and sold in an instant.
Unlike Mutual Funds, ETFs can be bought without an advisor, so there is a loss of expertise in the process. Additionally, ETFs may create a risk or suitability match for investors. An example would be a commodities ETF, which may actually be invested in futures or options or other derivative contracts while the investor believes that it holds the physical commodity. The shape of the futures curve will affect the returns on the ETF invested in derivatives, and without reading the prospectus, the investor may not understand what they have actually purchased.
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