Mutual Fund & ETF Structure Bookmark and Share

Both mutual and exchange traded funds have their similarities and differences as well as their advantages and disadvantages. In this article, we provide a overview of each fund structure and some details that are essential to an investing decision. Both mutual and exchange traded funds are structured as "open-end" management companies. This means that company distributes and redeems shares of the fund that it issues. This is in contrast to a "closed-end" company which only issues a fixed number of fund shares. Both mutual and exchange traded funds invest in a variety of assets that include stocks, bonds, money market instruments, commodities, and currencies.

Mutual Funds

The most important concept when it comes to mutual funds is the concept of Net Asset Value, or NAV. The NAV represents the value of all the assets that the fund is holding minus the funds liabilities. It is published at the end of every trading day and is expressed on a per share basis. As an investor, you are investing because you expect the NAV to increase over your investment horizon.

When buying or selling a mutual fund, and investor places his or her order during the day, and the transaction is executed at the end of day after the NAV has been calculated. An investor purchases shares in a mutual fund at the public offering price (POP) which represents the NAV plus a potential sales charge. An investor redeems (sells) shares in a mutual fund at the NAV price.

How Do I Make Money?

As an investor, you can make money in three ways from investing in a mutual fund:

  • Dividend Payments

    • On the securities in its portfolio, a fund receives dividend payments and/or earns interest. The fund then pays its shareholders nearly all of the income (minus disclosed expenses) it has earned in the form of dividends. When an investor initially purchases shares of the fund, he/she has the option of automatically converting these dividend payments into additional fund shares.

  • Capital Gains Distributions

    • If a fund sells a security that has increased in price, it has a capital gain. At the end of the year, funds usually distribute these gains (minus any losses) to investors. Investors can also elect to have capital gains distributions automatically convert to additional fund shares.

  • Increase in NAV

    • This is the way most investors expect to make money in a mutual fund. If the market value of a funds portfolio increases after subtracting expenses and liabilities, then the NAV of the fund increases. The higher NAV reflects the higher value of your investment.

What Fees do I Have to Worry About?

One of the reasons some investors shy away from investing in mutual funds are the numerous fees they charge for professional money management. Funds incur costs such as shareholder transaction costs, investment advisory fees, and marketing & distribution expenses. These fees lower your returns, but have to be disclosed by each fund in a "fee table" that is near the front of the fund's prospectus. The most important fees are discussed below:

  • Upfront Sales Charge (Front-End Load)

    • This is the amount you pay when you buy shares in a mutual fund. Let's say you invest $10,000 in a fund that has a 5% front-end load. The 5% or $500 comes off the top and you only end up investing $9,500 in the fund.

  • Deferred Sales Charge (Back-End Load)

    • This is the amount you pay when you sell shares in a mutual fund. The most common type of back end load is the contingent deferred sales load (CDSC or CDSL). The amount of the load is dependent on how long an investor holds his or her shares and usually decreases to zero after a prespecified amount of time.

  • Management Fee

    • This fee is paid out of fund assets to the portfolio's investment advisor for his or her services.

  • Distribution/Service Fees (12b-1 Fees)

    • These fees are paid out of fund assets to cover the costs of marketing and selling fund shares and sometimes to cover the costs of providing shareholder services.

When considering the impact of fees on the value of your investment, it is important to look at the funds Expense Ratio. The Expense Ratio is the line of the fee table that represents the total of all of a fund's annual fund operating expenses, expressed as a percentage of the fund's average net assets. Actively managed funds when compared with passively managed (index) funds have higher turnover in their portfolio and thus higher expenses.

How Do I Lower The Fees?

It is possible to buy many mutual funds without paying a sales charge. These are called no-load funds. In addition to being available from the fund company itself, no-load funds may be sold by some brokers for a flat transaction fee or even no fee at all.

In addition to no-load funds, mutual funds issue more than one class of shares. Each class invests in the same portfolio of securities and will have the same investment objectives and policies. But each class will have different shareholder services and/or distribution arrangements with different fees and expenses. As a result, each class will likely have different performance results. Depending on their investment goals and time horizon, investors can select which class is most appropriate for them. The most common mutual fund share classes are the following:

  • Class A Shares

    • Typically impose a front-end sales load. However, have lower 12b-1 fees and annual expenses when compared with other share classes.

  • Class B Shares

    • Typically do not have a front-end sales load. They usually impose a back-end load instead as well as 12b-1 fees and annual expenses.

  • Class C Shares

    • Might have a 12b-1 fee, as well as a front-end or back-end sales load. However, the sales loads tend to be lower than for Class A or Class B shares. To compensate, Class C shares usually have higher annual expenses when compared with the other share classes.

Exchange Traded Funds (ETF's)

Exchange Traded Funds, or ETF's, are investment vehicles similar to mutual funds, but trade like stocks on major stock exchanges. ETF's have much lower expenses when compared with mutual funds and are the best way to invest in the market both quickly and cheaply. ETF's provide the easy diversification, low expense ratios, and tax efficiency of index funds, while still maintaining all the features of ordinary stock, such as limit orders, short selling, and options.

Because they are listed on exchanges, ETFs are actively traded and allow an investor to lock in a price for the underlying assets immediately. Investors make money in ETF's the same way they would in a mutual fund through dividend payments, capital gain distributions, and increased NAV (or in this case, share price).

Two types of ETF's that have become popular recently are the following:

  • Inverse or Short ETF

    • An Inverse ETF is a fund that tries to replicate the performance of a short position in an index. For example, if the index were to go down, the value of the ETF would go up. An example is the ProShares Short S&P 500 (SH) which replicates the inverse of the performance of the S&P 500. These are a great product for hedging in investment accounts that either cannot short or use options.

  • Leveraged ETF

    • Leveraged ETF's try to acheive returns that are more sensitive to market movements than your average ETF. For example, a 2x leveraged ETF on the S&P 500, might try and achieve a daily return that is 2 times that of the S&P 500. Leveraged ETF's use advanced financial engineering techniques such as equity swaps, derivatives, and rebalancing to try and achieve the desired return.

Why Should I Buy an ETF as Opposed to a Mutual Fund?

ETF's offer many advantages over the traditional mutual fund. Most notably, they offer lower costs and expenses, are more tax efficient, and are traded on an exchange.

For more information about mutual and exchange traded funds, please visit Morningstar.com.

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