The origins of the exchange traded fund go back to the index fund and, further back, to the mutual fund. The first and subsequent ETFs borrowed little more than the general framework from the predecessors, however.
Indeed, the ETF-preceding index fund was a direct response to failings within the mutual fund’s structure. While mutual funds were perceived to be the safest thing going before 1976, Vanguard Group research showed that the Standard&Poor’s 500 stock market index consistently outperformed the then-extant mutual funds. Yes, mutual funds made for a secure long-term investment, but the index fund allowed higher and even more stable returns on investment. The first ETF, the Vanguard 500, was billed as a structure primarily concerned with shareholder interests, as opposed to mutual funds, which attempt to serve the interests of both outside owners and shareholders.
The exchange traded fund represents the third generation of such market investment, an update to the index fund and an evolution which has adapted to modern exchange dynamics.
Though the differences between ETFs and their predecessors are myriad, the very basics remain similar. Like mutual funds and index funds, ETFs act as an investment company with the Securities and Exchange Commission, on the market and, ultimately, with the individual stockbrokers themselves. American ETFs also share with mutual funds the default documents on the fundamental laws and regulations regarding such investments: The Securities and Exchange Commission’s Super Trust Order, the Securities Act of 1933, the Securities Exchange Act of 1940 and a number of modifications added in the 1970s.
Similarities between ETFs and mutual funds pretty much end here, as the next level of creation and investment in ETFs answers to the principles of the index fund. In fact, ETF creation and redemption has been described as diametrically opposed to those of mutual funds.
The exchange traded fund can most simply be described as an index fund which is open-ended, is transacted in intraday trading over an exchange, and involving no actual cash changing hands.
Index funds are often referred to as “passive investments,” meaning that they are indirectly tied to a securities index. This offers further protection against short- and medium-term inconsistencies in market activity, thereby allowing a fund manager to make as few decisions as possible regarding portfolio transactions while saving on transaction costs. The advantage of mutual funds is the low trading needed. In ETFs, this management can be reduced to a single informal audit once a year.
Traditional mutual funds often appeal to the small investor simply due to familiarity, whereas ETFs were born in the 1990s and are unknown in detail to many small-scale market players. Quite a few mutual funds consistently outperform the markets, but working against mutual funds are numerous data and independent research that reveals the risks inherent in mutual funds, namely that the chance that a star mutual fund beats the market next year is pretty much 50/50.
In ETFs and index funds, investors deal with blocks of stocks in an attempt to regulate the stock market index; this reduces risk through the stabilizing effect of blue chip stocks. The ETF takes this further, based as it is in a market sector or even a commodity, with obvious advantages. An investment in a copper-, gold- or Euro-based exchange traded funds would surely have netted nice, easily predictable returns throughout 2005 and into 2006. Because the growth in value of commodities and currency is medium-term at least, ETF creators can even release a fund on the open market in response to a new rise in value with plenty of time for investors to jump on board.
Unlike mutual funds, individual shares within ETFs and index funds are not redeemable in part. Index funds allow the investor to place his or her money in an index which typically covers hundreds of actively traded stock firms or commodities at once. As in index funds, ETF investors deal with blocks of stocks in an attempt to regulate the stock market index; unlike mutual funds, individual shares within ETFs and index funds are not redeemable in part.
This leads into the absolutely most critical part of understanding the revolutionary nature of the exchange traded fund: All transactions in exchange traded funds are cash-free, and thus the ETF is not to be considered a standard liquid asset. Because ETFs deal in creation units at the source level of the investment company, a securities portfolio of shares in like ratio to the creation unit is exchanged with the seller at the point of sale.
Always touted in discussion on exchange traded funds is the expense ratio in such an investment, with figures given notably lower in favor of the former. Estimates on such vary, but according to most sources the ETF expense ratio never tops one percent and rates of 0.1 percent are common; meanwhile, a mutual fund investor’s expense ratio starts at two percent and is typically higher.
Number two selling point of the ETF is its promised tax efficiency. Mutual funds truly fall by the wayside here for investors with no hope of proper tax hedging. Lipper magazine performed a study involving ten years’ worth of mutual fund gains and the concomitant tax rates. The Lipper study showed that up to 1.8% could be lost due to taxes in 1992-2002, resulting in a whopping 25% cut in returns. The long-term investment opportunity that had always been the main selling point of the mutual fund can be precisely the opposite, and more savvy twenty-first century investors are paying attention to what at first glance is an insignificant tax rate.
Tax inefficiency in mutual funds can be blamed on the mutual fund’s structure in which a new investor jumping into an extant pool may find himself or herself suddenly instantly confronted with a tax liability based on capital gains amassed before he/she invested at all. A second feature that makes mutual funds weak in tax efficiency is portfolio turnover. Trading activity – even that of other independent shareholders – can cause an increase in the unaware investor’s taxes simply through abundant buying and selling.
Exchange trade fund investment can avoid these twin pitfalls because ETFs can offer the same tuck-away functions as traditional mutual funds, but the intraday trading facet of the exchange traded fund allows greater management of potential taxes and shields from activities of fellow ETF investors.
In American mutual funds, the profitable fund is required by law to distribute any capital gain to its shareholders. Concomitant to these earned returns, however, is federal tax regardless of future investment with the returns. The ETF is not redeemed by stockholders and investors can sell in open trading; capital gains can thus be held until the investor chooses the sell, effectively acting as a tax hedge for the proverbial “rainy day.”
In the medium term, the risk inherent in mutual fund investment becomes apparent: Valuation of mutual funds is set based on the final closing price of day trading. Mutual funds can drop significantly in value well before the investor can act. In contrast, the intraday trading available to ETFs allows time enough to sell.
Connected with the mutual funds versus exchange traded funds debate, careful investors should be aware of the differences between ETFs and the closed-end fund or CEF. This investment scheme is often passed off as an actual ETF itself (indeed, many online brokerage services deal with CEF issues on an ETF page or FAQs list), but does not have the open-ended features of the exchange traded fund. Sometimes perceived of as a new product, CEFs are actually as old as mutual funds themselves and represent nothing more than a mutual fund with shares tradable on exchanges. While ETF shares trade on exchange, the ETF can be redeemed in kind and thus deviation from the real index value is minimized.