The Difference Between ETFs and Open-Ended Mutual Funds
Using an ETF is one way to invest in the stock or bond market without buying individual stocks or bonds. An exchange-traded fund is much like a regular mutual fund in that when you buy a share of an exchange-traded fund each share represents a tiny slice of all of the funds' underlying investments, allowing you to diversify across a pre-determined set of stocks or bonds by owning one single fund.
Most exchange-traded funds function like an index fund. For example, let's say you buy an S&P 500 Index exchange-traded fund; that fund will own all 500 stocks listed in the S&P 500 index. It will not trade in and out of those stocks - it simply owns the stocks listed in the index. By buying a share of the fund your money is instantly diversified across all of the underlying stocks.
Exchange traded funds differ from regular mutual funds in the way they are priced and in the way they trade, which means you can apply certain trading strategies with an exchange-traded fund which you cannot do with a regular mutual fund.
Pricing of an Exchange Traded Fund
A regular mutual fund sets its price once each day after the market has closed. The actual price you trade at is unknown because orders are placed during or before a market close and then"filled" at the closest new market value. The closing value will be repriced based on the number of shares bought and sold and the net asset value of the total fund.
An exchange-traded fund prices just like a stock with fluctuations to the penny throughout the trading period. Since exchange trade funds price throughout the day, you can purchase or sell them mid-day, buy on a dip in the market, or sell on a rally. Because the stock market prices are influenced by current news and worldwide opinions, the prices are prone to sudden and frequent impulse changes.
Because the calculating of share value is automated, it is fascinating to watch the changing prices. One advantage ETF's have over regular mutual funds is typically a lower operating expense fee which means you are paying less to own the fund.
Trading of an Exchange Traded Fund
When you buy or sell shares of a regular mutual fund you buy or sell them directly to and from the investment company that issues them, so you cannot trade them mid-day, nor can you use trading strategies like limit orders. You will buy shares of mutual funds in dollars, which means you may end up with an odd number of shares, including fractions. When you sell a mutual fund, it will be in shares, not dollars.
An exchange-traded fund, however, trades like a stock, pricing throughout the day. When you buy or sell it, you are trading it with other investors who are buying or selling. Since an exchange-traded fund trades in this way, you can use trading strategies such as limit orders or stop losses, which allow you to specify a specific price at which you wish a transaction to occur. You will buy or sell in shares, not dollars.
Are Exchanged Traded Funds Good in Retirement?
If you are building a portfolio of index funds, the exchange-traded version of the fund will be just fine. ETFs can also be used to target specific sectors of the market or particular industries that you want more exposure to. However, in retirement, stay away from leveraged ETFs - they can cause quick gains, or catastrophic losses - all in a short period of time.