What is an Exchange-Traded Fund?
Exchange-traded funds or ETFs are investment vehicles that are consist of various products based on a specific trading asset. In this manner, investors are able to trade a diversified suite of assets such as bonds, equities, and digital currencies etc. ETFs are listed and traded on traditional stock exchanges to ensure liquidity.
Types of ETFs
Traditional ETFs
Traditional ETFs contain traditional trading products such as stocks and bonds etc. They can also be based on specific benchmark indexes. They are issued by a firm that hold the underlying asset in an enterprise reserve and issue shares based on the proportional interest. Each share of the ETF represents a part of the total asset reserve that serves as warrant for investors.
Digital Asset ETFs
Digital asset ETFs are usually based on virtual currencies. They allow investors to invest in a group of digital currencies or digital currency-backed futures contracts.
Features of Exchange Traded Funds
Passive Investment
ETFs use passive investment strategy to mimic the performance of a given market index. This approach reduces administrative costs and adds more transparency. In this manner, passive investment lowers expense ratio for ETFs.
Index Tracking
ETFs track the performance of benchmark indices for the underlying trading assets or portfolio. The ETF managers utilize various strategies to replicate the performance of a given index.
Liquidity
ETFs also adopt various methods to introduce greater liquidity such that investors are able to easily purchase and sell its shares. Indicators such as low bid-ask spread is associated with higher liquidity and vice versa.
Expense Ratio
Expense ratio is the total operating cost of a fund. Investors tend to look for ETFs that have a low expense ratio and high long-term profitability.
What are Mutual Funds?
Mutual funds are pooled investment vehicles that are operated by trained fund managers. They pool funds from various investment sources to create a diversified portfolio based on products such as bonds and stocks etc.
Mutual fund shares are also listed on stock exchanges and each share represents portion of fund’s backing reserves. These funds use centralized management where fund managers make decisions concerning asset allocation, purchase and sales timings, and security selection etc.
Differences Between Mutual Funds and ETFs
Management Strategy
ETFs utilize a passive trading strategy to leverage advantages such as decentralization and lower operating costs. On the other hand, Mutual funds incorporate an active management approach.
Trading Frequency
Investors can purchase or sell ETF shares throughout the trading day. However, mutual fund shares are only traded once a day depending on the net asset value.
Transparency
ETFs often publish the fund updates with the investors on a daily bases therefore, they have a higher transparency. On the flip side, mutual funds often conduct shareholder meetings at quarterly or semi-annual basis that minimizes their transparency.
Expense Ratios
The operating cost of ETFs is lower thus the expense ratio is also economic. Meanwhile, mutual funds often have a higher expense ratio.
Liquidity
Liquidity of ETFs is higher on account of greater trading frequency. In contrast, mutual funds offer lower liquidity.
Tax Implications
Taxation for ETFs is higher on account of in-kind transactions while for mutual funds it is lower on account of cash-based transactions. However, digital asset ETFs and mutual fund taxation process are more similar.
Minimum Investment
Minimum investment threshold set for ETFs is often lower in comparison to mutual funds.
Registration
ETFs are regulated and approved by SEC in the light of Investment Company Act of 1940. At the same time, mutual funds are also registered by SEC based on the same legislative framework.
However, mutual fund managers have to submit N-1A form as a disclosure for necessary information such as objectives, fees, and trading risks. Both ETFs and mutual funds are obligated under law to file quarterly and annual reports with the relevant regulatory agency.
Conclusion
ETFs and Mutual Funds are two different types of investment options that have some similarities and differences. Investors can diversify their portfolio by learning about structure and working mechanism of both types of investment options.
