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This chapter is from the book

ETFs Are Traded on Exchanges

The big difference between ETFs and regular mutual funds is that as an individual investor, you buy ETFs on a stock exchange. You do not deal directly with the sponsoring mutual fund company, and you bear the full costs of every transaction you make. Whether this is an advantage to you depends on how you are using ETFs.

For example, when you purchase shares of a regular mutual fund, such as Vanguard’s S&P 500 Index Fund (VFINX), you send your money to Vanguard, and it creates new shares of its fund for you. The price per share is based on the value at the market close of the fund’s holdings on the date of your purchase. Conversely, if you want to redeem from a Vanguard fund, Vanguard eliminates your shares and sends you the cash value, again based on the value of the assets in the fund at the market close on that day.

With regular (open-end) mutual funds, buyers and sellers receive the same price for their shares on any given day, regardless of how the market behaved, and regardless of how many other shareholders in the fund might be buying or selling on that day. If you buy new shares, the mutual fund manager might be unable to put your money to work until the next day, when the fund will have the chance to purchase additional shares. If you redeem mutual fund shares, the fund manager might have to raise the cash you have requested by selling some of the fund’s holdings the next day. The necessity of engaging in such transactions to accommodate shareholder additions or redemptions might hurt the performance of the mutual fund, but it does not affect the price per share you pay or receive.

In contrast, when you purchase an ETF, you call or e-mail your stockbroker just as you would to buy stock in an individual company. When you purchase an ETF, you must pay a broker’s commission, similar to the charge you would incur to buy an individual stock. Note the difference between the likely size of a commission on the purchase of ETF shares and the sales charge on the purchase of a mutual fund with a sales load. Competition among brokers has driven the cost of buying ETF shares to low levels at many brokerage firms (including online brokerages and discount brokerages). However, the sales loads on mutual funds remain far larger than the cost of buying shares through a discount broker. Sales loads are generally as high as 5 percent of the assets you are investing.

You pay this sales charge either as a lump sum up front or over a period of years. When the sales charge is collected over a period of years (for example, 0.75 percent of assets per year for seven years in a typical class B load mutual fund share), you pay a “deferred sales charge” if you try to exit the fund before the full sales charge has been paid to the broker.3

When you purchase shares of an open-end mutual fund, the number of outstanding fund shares increases because the fund company takes your cash and creates new shares that are delivered to your account. The mutual fund generally puts the cash it received from you to work by using it to buy stock. Similarly, when you redeem shares of an open-end mutual fund, the fund company takes your shares and eliminates them, thereby decreasing the number of outstanding shares. In return for your shares, the fund company places cash in your account. The mutual fund generally sells shares of stock it owns to raise the cash it has to give to you.

Unlike mutual funds, which need to create new shares to meet your purchases and to eliminate existing shares to meet your redemptions, when you buy or sell ETF shares, you conduct the transaction with another investor. You and the other investor exchange ETF shares for cash, but the number of outstanding ETF shares does not change as a result of your transaction. Only the list of shareholders changes.

As an example, let us compare what happens when an investor purchases 100 SPY at $127/share to what happens if the same investor instead purchases shares in an open-end S&P 500 Index Fund (ticker ABCDX) that sells for $50/share. The outline that follows compares the purchase of ETF shares to the purchase of shares in an open-end mutual fund.

Case 1

Case 2

Investor A has $12,700 that he wants to invest in the ETF that tracks the S&P 500 Index (ticker SPY). Investor B has 100 shares of SPY that she wants to sell at $127.00/share.

Investor A has $12,700 to invest in an open-end mutual fund (ticker ABCDX) that tracks the S&P 500 Index. The share price of ABCDX is $50/share.

Before purchase by Investor A:

Before purchase by Investor A:

  • Investor A has $12,700 cash.
  • Investor B has 100 SPY.
  • Total SPY outstanding = 100 shares.
  • Investor A has $12,700 cash.
  • Fund ABCDX has 2,000 shares outstanding at $50/each, for total assets of $100,000. This $100,000 in fund assets is entirely invested in the basket of stocks that tracks the S&P 500 Index.

After purchase by Investor A:

After purchase by Investor A:

  • Investor A has 100 SPY.
  • Investor B has $12,700 cash.
  • Total SPY outstanding = 100 shares. (No change from before the purchase by Investor A.)
  • Investor A has 254 shares of fund ABCDX.
  • Fund ABCDX holds shares of stock worth $100,000 plus $12,700 cash, for total assets of $112,700 (an increase from before the purchase by Investor A). The new cash in the fund will be used to purchase more shares during the next trading day.
  • Total number of ABCDX shares outstanding has increased from 2,000 to 2,254, but each share is still worth $50.

Every transaction in an open-end fund for the entire day receives the same price. An order placed with a fund at 9:00 a.m. gets the same closing price for the day as one placed at 3:59 p.m. That closing price is set based on data from the market close at 4:00 p.m. Any order received at a mutual fund after 4:00 p.m.—even 4:01 p.m.—receives the next day’s closing price.

With ETFs, as with stocks, the price you get for your order can change throughout the day. Suppose that you buy an ETF early in the trading day (say, at 10:00 a.m.), and then at 11:00 a.m. some news comes out that drives the market higher. In this case, you will profit from the timing of your order. However, mutual fund purchasers will not. Of course, the reverse can also be true—namely, that the timing of your order can result in your getting a less favorable price than would have been the case if you had waited until the end of the trading day.

If you are a day trader, the ability to trade ETFs throughout the day makes them useful to you in a way that other mutual funds are not. Indeed, many hedge funds use ETFs specifically to be able to day-trade. If you trade more slowly, holding positions for days or weeks or longer, or if you are a long-term investor, the ability to trade during the day will probably not affect your investment performance one way or the other, on average.

For investors who utilize end-of-day trading strategies, ETFs have a big advantage that does not apply to individual stocks or mutual funds: Many ETFs trade until 4:15 p.m.—15 minutes after the regular market closes at 4:00 p.m. This allows you to wait until the market close to collect data and then use that data to decide which trades to execute on the same day.

In my experience, any trading model that utilizes daily data from the market close is likely to perform more poorly if trades are not executed on that same day. Investors who use mutual funds that allow unlimited trading (such as those offered by Rydex, Profunds, and Direxion that are designed to accommodate active trading) must submit their buy or sell orders to the mutual fund before the market closes. There is a chance that some trading decisions made before the close will turn out to be different from the decisions that would have been made if the final closing data had been known earlier.

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