Understanding Exchange-Traded Mutual Funds

By Lawrence Carrel

Exchange-traded funds, better known as ETFs, are the mutual funds for the 21st century. They’re investment companies similar to mutual funds but have some significant differences and advantages. The easiest way to think about ETFs is as mutual funds that trade on an exchange like stocks. They’re a fairly new concept made possible by the wonders of modern technology: computers. Seventy years ago, when the Investment Company Act of 1940 gave birth to the modern mutual fund, computers weren’t around in the financial industry. As a result, a fund manager had to wait until the market’s close to price the stocks in each portfolio and determine its net asset value (NAV). This method is still the modus operandi for mutual funds, but ETFs play by different rules.

Although the ETF determines its true net asset value (NAV) this same way every evening, during the trading day ETFs can move away from the NAV. ETFs trade like stocks based on the demand for shares, so their prices fluctuate throughout the 9:30-a.m.-to-4-p.m. session.

ETFs come in two varieties: open-end investment companies (funds) or unit investment trusts (UITs). The main difference between them is that open-end funds have fund managers and UITs don’t. However, neither type has restrictions on how many shares it can sell; ETFs can sell as many shares as needed to fill investor demand. And when investors want to sell, they redeem the shares back to the ETF, taking the shares out of circulation.