Mutual Funds Vs. ETFs

Which is better??

It depends upon the type of investor. The traditional, less sophisticated IRA investor who reallocates strategically, rather than tactically, keeps expenses low and is not a stock picker, may find the process of purchasing shares from a mutual fund company and redeeming them a simpler process. Additionally, plan sponsors’ use of mutual funds is well entrenched. Indeed, the ICI reports in its 2011 Investment Company Fact Book that close to $5 trillion is invested in open-end mutual funds within IRAs and defined contribution plans.

Individual ETF investors, on the other hand, tend to be more sophisticated, owning individual securities in both their tax qualified and non-qualified accounts, alike. Institutional investors use them, as well. ETFs trade throughout the day, may be purchased on margin and sold short. ETFs also afford the investor exposure to myriad markets and asset classes. Most are passive investments (track an index), but some offer active and complex approaches.

Institutional managers (separate accounts, hedge funds) that use leverage, take directional bets, hedge (pairs trading and market neutral strategies) or tactically allocate asset classes, use ETFs that prove to be less expensive and more nimble. These vehicles are more transparent than their closed-end fund (CEF) forebears, which lack theauthorized participant, a built in market making device. This feature of the ETF allows for daily creation and redemption of shares, which minimizes differences between the ETF price and its net asset value (NAV). CEFs issue a fixed number of shares, in contrast, which lead to continued differences between the share price and the NAV, creating an arbitrage opportunity.

Trading Process

ETFs offer greater flexibility than mutual funds when it comes to trading. Purchases and sales take place directly between investors and the fund. The price of the fund is not determined until end of business day, when net asset value (NAV) is determined. An ETF, by comparison, is created or redeemed in large lots by institutional investors and the shares trade throughout the day between investors like a stock.

Like a stock, ETFs can be sold short. Those provisions are important to traders and speculators, but of little interest to long-term investors. But, because ETFs are priced continuously by the market, there is the potential for trading to take place at a price other than the true NAV, which may introduce the opportunity for arbitrage.

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