Tag Archives: ETF

Types of mutual funds: Traditional Funds vs. ETFs

When people think about traditional mutual funds they typically think about funds known as “open ended funds.” They are the most commons funds. Shares of the fund are bought or sold though the fund company. There are no limits to the number of shares that can be issued and shares prices are determined once a day, after the market closes. At that point the total value of the assets in the mutual fund are determined and divided by the number of shares. This is the “net asset value” (NAV) and everyone who buys a share on that day pays the same price and everyone who sells also gets the same price, not matter what time of the day the order to buy or sell has actually been entered.

“Exchange Traded Funds” (ETFs) are newer but have become popular because they are bought and sold like a stock and are traded on major exchanges. The price of the shares can fluctuate during the day and the price that an investor pays for the shares can be different from minute to minute, just like the price of a stock will fluctuate during the day. That means that an ETF can be bought in the morning and sold in the afternoon for a profit or a loss depending on the change in value. The market price of an ETF is kept near the NAV by large institutional investors who will detect any difference between the NAV and the actual share price and use “arbitrage” to make that difference go away.

Because ETFs are more flexible in terms of trading strategy, they have become very popular with many active investors and speculators. In addition, because many ETFs are “passive” funds they often have lower expense ratios than many traditional mutual funds.

There are a number of other issues that an investor should be aware of with ETFs such as liquidity, commissions to trade, the bid-asked spread, and the viability of any specific ETF.

As always, consult your investment advisor.

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Schwab and the 401(k) plan.

We mentioned in a previous post that Charles Schwab (full disclosure, we use Schwab as our custodian) is working to introduce an ETF 401(k).  We believe that there may be advantages for ETFs in retirement plans.  However, in an interview with the Wall Street Journal, Steven Anderson, the head of Schwab’s retirement plan business made a point that cannot be over-emphasized.

“There’s been a fairly significant shift of risk from employer to employee in the past 30 years. Individuals weren’t prepared at that point, nor are they prepared today to save for retirement. Low balances put a general stress on the system, forcing people to work longer and make do with less, and education hasn’t been the tool we’ve been hoping it would be.”

The 401(k) type plan – referred to as a “defined contribution” plan has largely replaced the “defined benefit” – or pension – plan for most employees.  As these employees age, it becomes increasingly important that they make smart decision about how their money is invested.  Since most people are not sophisticated investors, being able to get professional guidance is critically important.  Providing guidance for this generation is our goal.

 

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What is an ETF?

Exchange Traded Funds, otherwise known as ETFs, are essentially index mutual funds that trade like stocks.  ETFs’ popularity is growing in part because some of the biggest names in the financial services industry are promoting them as alternatives to regular, or open-ended, mutual funds.

What’s the benefit of an ETF?  First, most have a low expense ratio.  An expense ratio is simply the amount of money that the fund charges in fees.  A second advantage is that an ETF can be traded (bought or sold) any time that the market is open.  For example, if you believed that the stock market was going to go up during the day, you could buy a stock market index ETF in the morning and sell it in the afternoon and capture the gain (or loss).  You can’t do this on an intra-day basis with a regular open-ended mutual fund.

What are the disadvantages?  Up till now the buyer or seller of an ETF incurred a commission, just like the individual who bought or sold a stock.  This is not the case with no-load mutual funds that don’t charge a fee for either buying or selling.  That is in the process of changing as some of the biggest names like Schwab and Fidelity are offering free trades on a growing number of ETFs.

The other disadvantage for the typical investor is that most ETFs are index funds rather than actively managed.  That means that there is no-one actually making a decision about what stock or bond to buy, sell or hold.  Buying an EFT requires your active participation and management or you risk putting your investments on auto-pilot and hoping that they don’t crash.

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