An exchange traded fund refers to an investment fund in which assets such as stocks, bonds and commodities are held in its net asset value. The investment fund is managed by a fund manager charged with the trading of the assets in the stock exchange market. On the other hand, an open ended mutual fund is an investment scheme that equally stocks its shares in the stock market. The latter is also managed by a fund manager.
It should be noted that the exchange traded funds are in essence a slight variance of the open ended funds. The former, which is at times considered as an example of the latter, refers to a more collective group. As such, the two investments have similarities. For starters, both are essentially investment funds. They pass out as convenient forms of investments in which the potential investor simple purchases shares in the stock market. In addition, both funds are managed by fund managers. In both funds, the fund manager makes investment decisions based on professional advice. Further, both exchange traded funds and open ended mutual funds are under passive management. Therefore, they seek to track against the market index. The funds would not attempt to outperform during the rising markets and would also not take defensive positions in declining markets. In that respect, both funds would rather underperform in a rising market or take a contrary position that is not defensive in declining markets.
While the two are appreciated for their inherent similarities, it is their differences that lay a framework that would influence a potential investor to invest in one fund as opposed to the other fund. The differences range from the share pricing, market availability, among other factors. The differences between exchange traded funds and open ended mutual funds are discussed below.
The exchange traded funds are usually present in the exchange markets throughout the day. They would be availed to any buyer in the market who is ready and willing to offer the market price. The market price usually would be either below or above the Net Asset Value of the portfolio of assets in the investment. The exchange traded funds are only accessible at the exchange market. As such, the buyers would be well positioned to buy the shares floated in the exchange market. Open ended mutual fund, on the other hand, can be accessed directly through the company or in some events through a select broker. In this case, investors have the option to purchase the shares directly from the fund instead of through the exchange market. The pricing of the fund shares usually occurs only once in a day. The price is maintained constantly throughout the day as opposed to the pricing of the exchange traded funds that essentially fluctuate in response to the demand and supply.
The other difference is found in the redemption mechanism. For the exchange traded funds, the redemption process cannot be done individually through the fund. Instead, the shareholder has the option of transferring ownership through a sale in the exchange market to third parties. On the other hand, for the open ended mutual funds, the redemption process occurs through the fund company. The redemption amount is set based on the end of the day Net Asset Value. In the computation, the applicable fee is directly deducted from the end of day Net Asset Value. Consequently, in open ended mutual funds, the fund can buy back and sell its shares. This makes the number of shares floated and available a factor of the prevailing circumstances and varies according to the sales and purchases of shares during the day. This is as opposed to the exchange traded funds in which the shares are fixed and only transferred from one investor to another without involving the company substantially.
Another point of departure between the two funds lies in the tax implications that the transactions cause. In exchange traded funds, transactions would lead to tax consequences limited to the transacting shareholder only. However, the gains in the transactions are distributed to all shareholders. Ultimately, the transacting shareholder incurs the tax expense but is compelled to distribute the gains to all shareholders. On the other hand, in the open ended mutual funds, a shareholder’s transaction generates tax consequences for all shareholders. In an equal measure, the gains from the transaction compulsorily devolve to all shareholders. Another rather minor difference could be observed in light of the disclosure requirements. The exchange traded funds disclose their holdings on a day to day basis making it one of the most transparent forms of investment. For the open ended mutual fund, the disclosures are on a quarterly basis limiting the amount of knowledge in the public domain on the actual holdings.
In conclusion, one should note that the two funds constitute forms of investments in the current markets. The exchange traded funds are in essence a slight variance of the open ended funds. Therefore, these two funds have both similarities and differences.
Becket, Michael. How the Stock Market Works: A Beginner's Guide to Investment. New York: Kogan Page Publishers, 2012.
Doukas, John. Emerging Capital Markets: Financial and Investment Issues. New York: Greenwood Publishing Group, 2008.
Melicher, Ronald W and Edgar A Norton. Introduction to Finance: Markets, Investments, and Financial Management. New York: John Wiley and Sons, 2010.