Exchange-traded funds (ETFs) combine some features of individual stocks with others that are characteristic of mutual funds. But that doesn’t mean these investment products are ungainly hybrids. Rather, they offer both individuals and institutions an easy-to-use alternative for converting their investment strategies into action, whether those strategies are as basic as diversification or as potentially complex as hedging risk.
ETFs vs stocks vs mutual funds overview
Like stocks, ETFs are listed on a securities exchange, purchased through a brokerage account, and traded throughout the day at prices set by supply and demand and other market forces. You can give a limit as well as market orders. You can sell ETFs short, buy them on margin, and on some but not all, purchase options contracts.
|Objective measure of value (NAV)||Yes||No||Yes|
|Must distribute gains to shareholders||Yes||No||Yes|
|Redeemable for cash||No||No||Yes|
Like mutual funds, each ETF owns a portfolio – typically referred to as a basket — of securities appropriate to its investment objective, which is stated in its prospectus. Similarly as well, an ETF provides its shareholders with the opportunity to benefit from the collective performance – or share the losses — of the fund’s underlying investments without having to purchase them individually.
Mutual funds and ETFs, but not exchange-traded commodity funds or notes, are governed by provisions of the Investment Company Act of 1940, which among other things limits their use of leverage and requires a daily valuation.
All ETFs traded in the United States are required to report the weighted holdings of their portfolios every trading day, making them the most transparent pooled investments in the market. Mutual funds, on the other hand, must report their holdings quarterly though some do so monthly. This means that the return that is calculated for an ETF can’t be manipulated by changing the portfolio’s makeup in the days preceding a required reporting. It also makes it easier to identify portfolio overlap, which occurs when two or more of the funds you own have large holdings of the same securities.
The index connection
Most ETFs are passively managed investments, each one linked to a specific market index. Like index mutual funds, ETF portfolios typically replicate the holdings of the index. However, when the holdings number in the thousands, the ETF typically includes a representative sample.
Other ETFs use more aggressive sampling designed to outpace the index. And a small number Of ETFs are actively managed rather than index-based. In both cases, mathematical models play a major role in selecting the underlying securities or other investment products.
As interest in ETFs has grown, so has the number of indexes available to track. While the earliest funds were linked to broad market indexes, such as a major benchmark for US Stocks, and MSCI EAFE, a major benchmark for international stock in developed markets, the current roster is much more diverse. It includes indexes tracking very narrow market segments as well as fundamental indexes, whose components are selected based on factors such as revenue, sales, profits, and dividends, and other indexes grouped under the nontraditional label.
The underlying premise of index investing, at least when the index in question is a broad market index, is that it’s the most effective and efficient way to achieve the strongest long-term return.
Efficient, in this context, means more cost-effective. It’s generally much cheaper to invest in an ETF or index mutual fund than in an actively managed fund with a similar objective and much cheaper than investing in a well-diversified portfolio of individual securities. It’s also less labor intensive for the investor, which adds another level of efficiency.
For proponents of efficient market theory, index investing is also efficient because everything that is known about an investment is incorporated into its price. So it’s virtually impossible to beat a market — as represented by an index tracking that market — consistently.
The next wave
Some ETFs link to indexes with a particular purpose. For example, the objective of a strategic, thematic, or factor index — sometimes identified as third generation or alternative indexes — is delivering a return that not only differs from the market return but provides a clearly articulated advantage. An environmentally-focused index probably excludes companies that don’t meet its standards.
A risk control index might hold some combination of stock and cash to help offset market losses. In fact, if you find an ETF focused on an objective that’s important to you, just wait. It probably won’t be long.
What Is The Difference Between ETF vs Mutual Funds vs Stocks? by Inna Rosputnia
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