Exchange Traded Funds (ETF’s for short) are baskets of investments that in many ways resemble more familiar mutual funds. ETF’s have key differences from mutual funds, however, and these differences might make them inappropriate as a replacement in your portfolio for mutual funds.
The main feature shared between ETF’s and mutual funds is diversification. Both types of investment vehicles hold within them dozens, sometimes hundreds, of investments in various things: stocks, bonds, other mutual funds or ETF’s, precious metals, etc. In this way, a buyer of an ETF or a mutual fund can create instant diversification in his or her portfolio with one purchase.
Another similarity between ETF’s and mutual funds is that both charge fees for operation. The fees are what the shareholders pay to the managers of either type of fund, which vary depending on who runs the fund in question and what kind of fund it is. Across the board, ETF’s charge less in fees than traditional mutual funds do.
Where the similarities between ETF’s and mutual funds largely end is in how they are traded. A mutual fund is priced only once each day at the end of trading after the markets have closed. Purchases and sales of mutual fund shares also take place at this time, after the price for the day has been determined. Thus, trading in and out of mutual funds is not instant.
ETF’s, on other hand, trade in the markets just like stocks. Buy and sell orders can be given on one’s ETF shares at any point in the trading session, and as such, the prices change constantly. In this way, an ETF is more like an individual company stock than a mutual fund.
It is this feature that makes ETF’s potentially inappropriate as a substitution for mutual funds in your portfolio. The reason is that since an ETF can be traded constantly, and since prices in the markets can swing wildly based on perception alone, the price of an ETF’s shares can wildly exceed or fall short of the value of the fund’s underlying investments. For example, if a ETF contains shares of a sector that is performing poorly, the price per share of the ETF itself can be driven down significantly and rapidly, even if the other assets within the ETF are on the rise. Additionally, since ETF’s are treated like common stocks, it is possible for traders to short ETF shares – borrowing shares and selling them to bet on a fall in the price per share – which can greatly affect the value of the ETF shares. Mutual funds, which only determine price once each day, allow purchases and sales only once each day, and cannot be shorted, do not suffer from these drawbacks nearly as much.
ETF’s and mutual funds share many similarities and advantages, but their differences do not make them exactly interchangeable. Therefore, before buying into either one, you should assess your needs and goals and determine if mutual funds, ETF’s, or perhaps some combination of the two are appropriate for your needs.