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Category: How To, Investing, Information July 25, 2008 - The USA Today Online News Service - Matt Krants Q: How are exchange-traded funds (ETFs) different from mutual funds? A: Exchange-traded funds and mutual funds are related in the way you might resemble a long-lost cousin living in a different state. ETFs and mutual funds look alike in many ways. Both are essentially single investments that own stakes in many other investments, such as stocks or bonds. Both offer great flexiblity to investors by providing a low-cost way to buy a basket of investments at one time at a relatively low cost. But under the hood, ETFs and mutual funds are quite different. Let's start with mutual funds. The type of mutual funds most people are familiar with are open-ended funds. These funds take investors' money, pool the cash and then use the cash to buy the stocks in their portfolio, such as the stocks in the Standard & Poor's 500. A mutual fund sets its share price, or net asset value, once a day, at the end of the day, which is when you can generally buy more shares of the fund. That price is based on the prices of the assets it owns. ETF shares, by contrast, are bought and sold on stock exchanges, such as the New York Stock Exchange or Nasdaq. Investors buy and sell shares that own a piece of the portfolio. All the buying and selling pushes the price of the ETF close to the value of the stocks or bonds it owns. On the back end, broker dealers can create new shares of the ETF by buying and depositing the sharescontained in the ETF. This is a techical aspect of ETFs that is better explained in detail, if you're interested, here. The structure of ETFs provides some distinct advantages. Their annual expense ratios tend to be much lower than those on many mutual funds. Additionally, ETFs are priced in real time during the day, like any other stock, and can be bought or sold any time the market is open. Trading in ETFs has been stable and strong, despite troubles in financial markets. Unlike some bond securities that have seen trading dry up, most ETFs are based on baskets of highly liquid stocks or bonds. That's very different than some troubled areas of the bond market, which held bonds that didn't trade much or that have had credit issues, says Gary Gastineau of ETF Consultants. ETFs mostly own publicly traded securities that can be bought and sold easily during the day. "You're dealing with readily and transparently valued instruments," he says. In addition, while some investment banks have been under pressure, there's little capital required to create ETF securities and keep the market functioning well, Gastineau says. Gastineau says he's considered any possible scenarios that could cause trouble for ETF trading, and "I don't see it. It's hard to believe you're going to have a serious problem." So even during a time the financial system is under some stress, Gastineau says ETFs are likely to function just fine. "There are a lot of things to worry about, but this (the trading and liquidity of ETFs) isn't one of them." Matt Krantz is a financial markets reporter at USA TODAY and author of Investing Online for Dummies. He answers a different reader question every weekday in his Ask Matt column at money.usatoday.com. To submit a question, e-mail Matt at mkrantz@usatoday.com. Click here to see previous Ask Matt columns. |
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