At Empirical, we generally advise individual investors to avoid investing in individual securities (such as single stocks or bonds), instead recommending the use of funds of these assets to get market exposure. The main reason behind this is the diversification benefit received from owning a portfolio of assets as opposed to a few individual assets, a benefit that would be highly impractical to achieve using only individual securities. However, not all fund structures are identical, and each structure has different consequences for investors. The two most common fund types are mutual funds and exchange traded funds (ETFs), and these two fund structures are the topic of this Investment Product Review.
Many investors are familiar with mutual funds, but it can still be instructive to review the basic idea. A mutual fund is a vehicle that pools investor money in order to purchase a portfolio of securities (e.g., stocks, bonds, commodities, etc.). The return to each investor is based on their share of the portfolio return, which in turn is comprised of the return of each individual asset in the fund. An example will help to clarify this. If a fund wanted to mirror the performance of the S&P 500 index, that fund would gather its pooled assets and purchase all of the stocks in the S&P 500 using the same weightings as the index. Thus, the return of the fund would be equal (before fees) to that of the S&P 500.
Mutual funds generally come in two forms: open-ended and closed-end. In both types of funds, at inception a particular number of shares are issued, and these shares determine ownership of the fund by investors. An open-ended fund issues additional shares every time there is an investment in the fund, and the newly invested money is used to expand the positions that the portfolio holds proportionally. The value of an open-ended fund is determined by the net asset value (NAV) of the portfolio at the end of each day, and this NAV is what determines the price of the mutual fund.
A closed-end fund does not create additional shares after the initial issuance. The price of a closed-end fund is determined by supply and demand, just like an individual security. As more investors buy into a closed-end fund, the price of that fund will increase, and vice-versa when investors leave the fund. At any given point, the price of the fund can be greater than or less than its NAV.
Exchange traded funds have some similarities to each type of mutual fund, and some distinct characteristics of their own as well. Like mutual funds, ETFs are investment vehicles of pooled investor assets used to create a portfolio of securities. However, whereas shares of mutual funds are bought from or sold to the fund company itself, ETF shares are traded on public exchanges, and generally transacted through a broker. Like closed-end funds, their price is determined by investor demand, and not by NAV, though the price will generally stay quite close to the NAV due to the way ETF shares are bought and sold at the institutional level, through a process called redemption in-kind.
The significance of these funds trading on exchanges is the fact that they can be traded like any other security on an exchange. They are traded and priced intra-day, and can be sold short and purchased on margin. ETFs also have other benefits to their investors as a result of their redemption process. If open-ended mutual fund investors sell their shares in large numbers, it can force the fund to sell some of its underlying securities in order to return money to the investors. This can cause the fund to create taxable capital gains for the investors still in the fund. Also, any income paid out by securities in a mutual fund (e.g., dividends, coupon payments, maturing securities) is recorded as taxable income as well. Neither of these issues exists for retail trading of ETFs, making them far more tax-efficient for the average investor.
The title of this review referred to mutual funds and exchange traded products. ETFs are the most common type of exchange traded product, but another example would be an exchange traded note, or ETN. An ETN is a debt security issued by a large financial institution, generally a bank, that is designed to pay out a value equal to the return on an index. For example, an ETN based on the S&P 500 would have identical returns to the index itself, minus the expense of the note. ETNs are attractive because of their ability to track without error a particular index or composite, something that is nearly impossible to achieve with any fund of securities. However, ETN holders are exposed to the credit risk of the institution that issued the note. If that institution defaults, the note holder may lose some or all of their investment. ETNs have become increasingly popular in asset classes that are harder to invest in directly, such as commodities and currencies.
At Empirical, we use both exchange traded products and mutual funds in our portfolios. The funds are evaluated on factors like their performance, cost, tax-efficiency, and appropriateness for the portfolio in question. Mutual funds are, on average, more expensive than ETFs, but because they can be created on a smaller scale, many mutual funds will offer investment exposure not available in ETFs. For example, many of the mutual funds we use are institutional, meaning they cannot be purchased by an individual investor without an advisor. In other asset classes, we find that ETFs offer a more cost-effective and efficient alternative. When choosing between mutual funds and ETFs there is no universal “better” option, each investment will need to be weighed on its merits.
 As mentioned above, when an individual buys ETF shares, it is through a broker. When the broker purchases ETF shares from the fund provider, they use in-kind transactions, meaning they purchase a specified number of shares not with money, but with the securities underlying the fund itself. Using our earlier example of the S&P 500 fund, redemption in-kind would involve exchanging a weighted portfolio of all 500 stocks in the index for a pre-specified number of shares of the ETF. This process is clearly cost-prohibitive for an individual, which is why most investors purchase ETF shares through a broker, but it also keeps share prices relatively close to NAV, because if the price and value diverged it could be arbitraged by an institution through the in-kind redemption process.