Exchange traded funds (ETFs) and mutual funds both use pools of investor money to buy securities, a technique which spreads the risk of buying and selling individual stock shares. Mutual funds have been around since the 1920s and about half of American households have some investment in them. ETFs began in the 1990s and as of the date of publication, there are about 1,000.
Mutual funds are not bought and sold on an open market like the New York Stock Exchange. However, ETF shares are actively traded, just like the individual stocks they hold in their portfolios and on the same markets. Mutual fund prices are based on "net asset value," which is determined at the end of each market trading day by calculating the number of shares in the fund against the worth of its assets. ETF prices are determined by investor supply and demand.
Mutual funds are either open-ended, with no limit on the number of shares that can be sold, or closed-end, with a fixed number of shares. Most ETFs are like open-end funds, with no limit on shares; however, there are two "trust" types, one of which limits investment options while the other gives shareholders direct ownership in the underlying stocks.
Both mutual fund and ETF shares are purchased through brokerage houses. Mutual funds are purchased directly from the fund, through a manager who invests the fund's assets in various securities. There are no price variations during a market day. ETF shares are bought and sold during a trading day with no involvement from the ETF manager; prices can vary with investor interest. An investor pays fees to a mutual fund manager, but pays brokerage commissions on ETF trades.
Either investment can be "indexed," based on a market tracker like the Standard & Poor's 500-stock Index. In these cases, fund managers buy stocks included in the index, so the fund performance mirrors the variations in the index. Popular ETF options are called "spiders" because they track the S&P;, "diamonds," based on the Dow Jones average or "cubes" that are tied to a NASDAQ index.
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