Mutual Funds and Exchange Traded Instruments (ETFs, ETNs, and CEFs) – An Introduction

Mutual funds (open-end fund) draw on money from investors to acquire stocks, bonds, or other assets. In return investors receive shares of the mutual fund proportional to these invested assets. The funds are considered open-end for the reason that shares can be continually issued or redeemed based on investor demand. Also absent for mutual funds is the secondary market– Investors buy shares from the mutual fund and redeem it by selling it back – no trading occurs between investors. On the other hand, with exchange traded instruments (ETFs, ETNs, and CEFs), shares outstanding increase or decrease less frequently and only in large chunks (multiple of “creation units”). They are called Exchange Traded as there is a secondary market for these instruments where they can be traded identical to any other stock.

The spreadsheet below compares the features of exchange traded instruments with mutual funds:

Comparison Term	Mutual Fund	Exchange Traded Instruments
Trades in an Exchange	No – bought/sold from/to the mutual fund company	Yes – Trades just like a stock.
Price	Net Asset Value (NAV) at the End of the Trading Day	Market Value that varies through-out the day. Could trade at a premium or discount to NAV.
Purchase Costs	More – except no-load mutual funds that do not have front and back-end loads – they still charge a small fee in most cases	Less – Brokerage fees and the bid-ask spread which is both relatively small.
Ongoing Fees	More – Actively managed funds have much higher fees while index mutual funds have lower fees although usually not as low as comparable Exchange Traded Instruments	Less.
Automatic Dividend Reinvestment	Yes	No
Options	No – not traded in stock exchanges at all	Yes
Granular Purchase Option	Yes – you can buy for any amount as long as minimums are met	No – you have to purchase whole shares (not fractional).
Minimum Investment Requirements	Mostly Yes	No with some exceptions
Portfolio Turnover	More – no protection against other investors redeeming shares thereby forcing the fund to realize capital gains/losses	Less – Immunity from tax consequences due to other investor activity
Capital Gains Taxes	Yes – ongoing	No – only when sold.
Cash Drag (Performance impact due to holding cash instead of other investments)	More – mutual funds usually hold more cash to satisfy on-going redemptions	Less – with certain exchange traded instruments that are structured as Unit Investment Trust there can be a cash drag because of a regulatory requirement to hold dividends in non-interest bearing accounts until distribution.

The three types of Exchange Traded Instruments (ETF, ETN, and CEF) can be summarized as:

ETF:

- With an Exchange Traded Fund (ETF), assets are acquired by selling large blocks of shares called “creation units.” Selling large blocks is a regulatory requirement and allows for the formation of a secondary market. Since no money is exchanged in the primary market (creation units are exchanged for large blocks), there is no tax event at that level. The creation units are sold, after being separated into a large number of individual shares, thus forming the secondary market.

ETN:

- Exchange Traded Notes (ETN) is structured as a debt instrument. Debt instruments by nature are prone to credit risk – risk involved with the debtor (in this case the entity that issues ETNs) not honoring the obligation. This situation arises if the issuing entity goes bankrupt or runs into financial trouble. ETN’s promise a return tied to an index or other market benchmark (less fees). As with ETFs, “creation units” and secondary market creation are applicable to ETNs too. However, ETNs are a riskier investment option due to the added credit risk involved – this risk is somewhat mitigated by the fact that issuing agencies usually have good credit ratings.

CEF:

- Closed End Funds (CEF) are launched through an Initial Public Offering (IPO) process and the funds realized are then invested. Shares are traded in stock exchanges thereby forming the secondary market. Since a fixed amount of money is raised at IPO, shares outstanding remain stable.

Below is a spreadsheet that summarizes how they differ from each other:

Comparison Term	ETF	ETN	CEF
Investor Holds	Shares that represent assets held	Shares that represent a Senior Debt Contract	Shares that represent assets held.
Recourse	Assets Held	Issuer Credit	Assets Held
Risk	Market	Market & Issuer	Market. The portfolio may use leverage which is an additional risk.
Institutional (multiple of creation unit) Redemption	Custodian	Issuer	NA
Benchmark Tracking Error	Yes	No – it is a prepaid contract	Yes
Valuation	Net Asset Value (NAV) – usually trades close to this value	Indicative Value based on associated benchmark level	Net Asset Value (NAV) – can trade at a significant premium or discount.
Maturity	None – investors can redeem anytime at multiples of “creation unit”	Varies – can be a few years to 30 years or more – investor receives cash that conforms with the investment return promised (benchmark return minus fees)	None, although there are exceptions
Distributions	Yes - dividends	None	Yes - dividends
Tax Treatment	Dividends taxed on an on-going basis. Capital gains taxed when selling	No on-going taxes. Capital gains taxed when selling	Dividends taxed on an on-going basis. Capital gains taxed when selling

Summary:

There are several thousands of mutual funds with more than ten trillion in assets under management. This compares to around thousand exchange traded instruments with close to a trillion in assets. Even so, exchange traded instruments offers far more flexibility and the fees on the average are fewer explaining the faster growth of exchange traded instruments compared to mutual funds. There are distinct structural differences within the three exchange traded instruments with associated differences in their investment and risk profiles. As with any investment vehicle, careful consideration needs to be given to these factors before committing money.

Related Posts:

1. Mutual Funds and Exchange Traded Funds - An Introduction.
2. Triple Leveraged ETFs - An Introduction.

Last Updated: 06/2009.