What is an Exchange Traded Fund?

An Exchange Traded Fund (ETF) similar to mutual fund is a collective investment vehicle that trades like a single stock. ETFs generally track the performance of a stock, bond, or commodity index. Similar to individual stocks, each ETF has a ticker and traded traded on a stock exchange. Major difference between mutual fund and ETF originate from the structural differences between the vehicles. ETFs can be managed much more cheaply therefore it provide a lower cost option for investors to track particular investment index.

Since its initial inception and original market index ETF. The industry has grown to an extent where there are specialized ETF that track specific components of the market such as healthcare. ETF that move opposite to the market or even access to asset classes where once it was not possible such as emerging market debt .

How do ETFs work?

An ETF is simply a basket of securities that trades like a single stock. This means that it provides the benefits of a collective investment vehicle and the benefits of owning an individual share. Similar to mutual fund, ETF invests in listed securities but because mutual fund is only priced once a day ETF has the advantage of allowing investors to track the value of the fund in real time.

From pricing perspective ETF have the implicit value of intraday trading. The difference in once a day pricing of mutual fund and option of real live trading of ETF means investors enter and exit at market prices for the ETF and NAV for mutual funds. Both options are the same with limited opportunity for arbitrage.

In addition to the liquidity difference between mutual fund and ETF. The disadvantage of intraday ETF trading is generally, an ETF is expected to trade close to the NAV of the underlying shares but the market price will fluctuate in accordance with changes in the NAV and the supply and demand for the ETF shares. Hence in volatile markets, the NAV of the ETF could deviate from the traded price.

Other Common Questions on Difference between Mutual Fund and ETF:

1. How are Dividends treated?  ETFs attract the dividends of the underlying investment in the same way as a normal fund. Whether these dividends are distributed on a regular basis or accumulated to the fund depends on the individual ETF.

2. How liquid are ETFs?    The relative liquidity of different ETFs depends to a large extent on the liquidity of the underlying stocks. The more liquid the underlying stock is, the easier it is for Authorised Participants or Market Makers to assemble the creation units which facilitate trading. This means it is possible for ETFs to be liquid even if they have low trading volumes.

With that said, investors should also be conscious of another aspect of liquidity, the bid and ask spread. While the volume could be there from ETF authorised participants or market makers it will come at a cost.

3. Can you short sell ETFs?  It is possible to sell an ETF short (sell an ETF one does not own in anticipation of its price falling), but availability for private investors will often depend on the type of account they have. Short ETFs have recently been developed that move contrary to the index, enabling private investors to speculate on price falls.

Summary of the difference between Mutual Fund and ETF

1. Easy to diversify the portfolio through using ETF that uses difference strategies

2. Liquidity As ETFs trade in real time on stock exchanges, they are liquid and can provide greater investment flexibility than mutual funds, which tend to trade only once a day.

3. Transparency With ETFs, information on underlying securities is published daily. With many types of pooled investments this is not possible.

4. Cost Efficiency ETFs tend to have relatively low annual expense ratios. There is no stamp duty or load fee, so costs are often significantly lower than those associated with traditional unit trusts and Open Ended.

5. Investment Companies (OIECs), so for many investors ETFs will represent a lower cost investment tool.

What should I consider when I evaluate an ETF?

Before buying an ETF, there are a number of general factors to consider – clearly you need to review all of the documentation published by the ETF provider and understand the risk of the investment. It is always worth checking for specific risks and any tax implications. ETFs with international exposure may well expose you to currency risk, for example.

Once you have decided on a strategy to pursue, there are a few key areas to look at when comparing ETFs:

1. Tracking error (the difference between the fund’s return and the index return) .

2. Transaction costs Each trade involved in tracking the underlying index properly involves  costs, including the spread between the bid and ask prices for each underlying equity.

3. Annual fees – a fee charged by the ETF Provider to cover the cost of running the ETF

4. Bid offer spreads the difference between the bid and offer price for an ETF. This is the price you pay to invest or to sell, rather than the NAV price. Bid/ask spreads should be within a tight range of the NAV.

Using ETFs within a portfolio

ETFs can be used as the building blocks to enable an investor to create an investment portfolio.

Index investing has been proven to be an effective way of investing, built on a simple principle instead of trying to beat the market, investors should own the market.

With the increased availability of ETFs, any investor can use them to compose a portfolio in an efficient and effective manner. A well diversified global portfolio consisting of a mix of equities, bonds and commodities can be assembled easily and cheaply by buying just a few ETFs.

For example list of types of investment portfolios can all be created easily using ETF

- Aggressive portfolios even including alternative assets

- Balance portfolios mix of stocks and fixed income