Frequently Asked Questions About How ETFs Compare with Other Investments

How are ETFs similar to mutual funds?

Mutual funds and exchange-traded funds (ETFs) share similarities and can serve similar purposes for investors. Both, for example, can provide the basic building blocks of investors’ portfolios. An ETF is similar to a mutual fund in that it offers investors a proportionate share in a pool of stocks, bonds, and other assets. ETFs are most commonly structured as open-end investment companies, like mutual funds, and are governed by the same regulations as mutual funds. Also, like a mutual fund, an ETF is required to post the marked-to-market net asset value (NAV) of its portfolio at the end of each trading day.

How are ETFs different from mutual funds?

One major difference is that investors buy and sell ETF shares on a stock exchange through broker-dealers, much as they would trade individual stocks. In contrast, mutual fund shares are not listed on stock exchanges. Retail investors buy and sell mutual fund shares through a variety of distribution channels, including directly from a fund company or through a financial adviser or broker-dealer.

Mutual funds and ETFs are also priced differently. Mutual funds are “forward priced.” Investors can place orders to buy or sell shares throughout the day, but all orders received during the day will receive the same price—the fund’s NAV at the next time it is computed. Most mutual funds calculate their NAV as of 4:00 p.m. eastern time because that is the time U.S. stock exchanges typically close.

In contrast, the price of an ETF share is continuously determined through trading on a stock exchange. Consequently, the price at which investors buy and sell ETF shares may not necessarily equal the NAV of the portfolio of securities in the ETF. In addition, two investors selling the same ETF shares at different times on the same day may receive different prices for their shares, both of which may differ from the ETF’s NAV.

How big are ETF assets relative to all assets managed by mutual funds and other investment companies?

At the end of September 2011, stock, bond, and hybrid mutual funds held assets of $8.4 trillion and ETFs held assets of $951 billion. The latest asset figures for closed-end funds and unit investment trusts totaled $292 billion. Thus, assets in ETFs accounted for 10 percent of the $9.7 trillion total net assets in long-term funds managed by investment companies by the end of September of 2011. For more on the U.S. ETF market, see “Frequently Asked Questions About the U.S. ETF Market.”

Are ETFs regulated in the same manner as mutual funds?

The vast majority of ETFs are registered with the Securities and Exchange Commission (SEC) under the Investment Company Act of 1940. Like mutual funds, these ETFs must comply with the applicable provisions of the Act. However, in order to operate, ETFs must receive SEC exemptive relief from certain provisions of the Act.

Different regulations apply to commodity-based ETFs, which hold about 12 percent of ETF assets. ETFs that invest in commodity futures are regulated by the Commodity Futures Trading Commission (CFTC), while those that invest solely in physical commodities are regulated by the SEC under provisions of the Securities Act of 1933.

What are exchange-traded notes (ETNs), and how do they differ from ETFs?

ETNs are unsecured debt securities, which, like bonds, can be held to maturity by an investor. These securities are registered under the Securities Act of 1933 but not under the Investment Company Act of 1940.

ETNs and ETFs share similar characteristics, principally that they both trade throughout the day on an exchange. Also, like many ETFs, an ETN’s value is linked to the performance of a given benchmark index.

However, because they are not funds, ETNs are not collateralized by an underlying portfolio of securities. Moreover, the value of ETNs can be affected by the credit rating of the ETN issuer. A downgrade in the issuer’s credit rating, for example, could cause the value of the ETN to drop.

January 2012