Mutual funds and ETF

Collective investments for the mass investor
Mutual funds and ETFs are the main vehicles for retail and institutional investors, enabling diversified investing with relatively low minimum contributions. Understanding their structure, economics, and differences is essential for investment professionals.

Mutual funds: structure
Open-end fund: a structure in which the fund issues and redeems shares at NAV (Net Asset Value). Investors buy shares directly from the fund, and the fund creates new shares. Upon redemption, the fund cancels shares and pays out the NAV.

NAV calculation:
NAV = (Total Assets - Liabilities) / Shares Outstanding
Calculated daily after market close. This price applies to all transactions that day.

Structure:

• The fund is a separate legal entity (or series of trust).
• Board of directors/trustees oversight.
• Investment adviser manages the portfolio under contract.
• Custodian holds assets.
• Transfer agent maintains shareholder records.

Mutual fund fees

• Management fee: an ongoing fee as a percentage of AUM, accrued daily, paid from fund assets. Typically 0.1% (index funds) to 1.5%+ (active equity). This compensates the investment adviser.
• 12b-1 fees: distribution fees, used for marketing, payments to intermediaries. Embedded in expense ratio. Maximum 1% annually, typically 0.25% for no-load funds.
• Sales loads: one-time fees upon purchase (front-end load) or sale (back-end load). Loads compensate distributors. No-load funds are increasingly dominant, loads are declining.
• Expense ratio: total ongoing expenses as a percentage of AUM. Includes management fee, 12b-1, administrative costs. Key metric for comparing funds.

ETF: mechanics
Exchange-traded fund: structure allowing shares to trade on exchanges like stocks. ETF shares are created/redeemed in large blocks (creation units) by authorized participants (APs), not directly by retail investors.

Creation/redemption:
AP delivers a basket of underlying securities to the ETF sponsor and receives creation units of ETF shares. Redemption is the reverse—AP returns ETF shares and receives the basket. This keeps ETF price close to NAV.

Arbitrage mechanism:
If the ETF trades above NAV (premium), APs create shares (buy basket, deliver for ETF, sell ETF) until the premium closes. If below NAV (discount), APs redeem. This arbitrage maintains price-NAV alignment.

ETF vs mutual fund differences

• Trading: ETF trades throughout the day at market prices; mutual fund transacts once daily at NAV. ETF offers intraday liquidity, ability to use limit orders, short selling.
• Tax efficiency: ETF structure is typically more tax-efficient. In-kind redemptions avoid realizing capital gains. Mutual funds may distribute capital gains to shareholders annually.
• Minimum investment: ETF—the price of one share (could be $50-500). Mutual fund minimums are often $1,000-10,000+ (though some offer low minimums).
• Costs: ETF expense ratios are often lower, especially for passive strategies. But ETFs incur trading costs (commissions, bid-ask spreads) when transacting.

Active vs passive

• Passive investing: tracking an index (S&P 500, total market), minimizing deviation from benchmark. Low-cost, consistent performance relative to the index. Dominant use case for ETFs.
• Active investing: attempting outperformance through security selection, timing, allocation. Higher fees justified by potential alpha. Most mutual funds are active, though passive is growing.
• Passive growth: massive shift toward passive in recent decades. Lower fees, difficulty of consistent outperformance drive flows. Now approximately 50% of US equity fund assets are passive.

Types of funds

• Equity funds: invest in stocks. Styles: growth, value, blend. Sizes: large-cap, mid-cap, small-cap. Geography: US, international, emerging markets. Sector: technology, healthcare, etc.
• Bond funds: fixed income. Categories by duration (short, intermediate, long), credit quality (investment grade, high yield), type (government, corporate, municipal), geography.
• Balanced/allocation funds: mix of stocks and bonds. Target-date funds automatically adjust allocation as target date approaches (for retirement saving).
• Money market funds: short-term, high-quality instruments. Seeks stable $1 NAV (though not guaranteed post-crisis reforms). Liquidity management tool.

Regulatory framework

• Investment Company Act of 1940: primary US regulation. Requirements: diversification, leverage limits, board oversight, disclosure. SEC registration.
• UCITS: European framework (Undertakings for Collective Investment in Transferable Securities). Passport across EU, investor protection rules. UCITS funds distributed globally.
• Disclosure: prospectus (detailed offering document), summary prospectus (key facts), shareholder reports (periodic performance, holdings). Transparency for investor decision-making.

Industry landscape

• Major players: Vanguard, BlackRock (iShares), Fidelity, State Street (SPDR), Schwab dominate. Scale economies, brand recognition create concentration.
• Fee competition: race to zero for index funds. Fidelity offers zero-fee index funds. Pressure on active managers to justify fees with performance.
• Innovation: thematic ETFs (clean energy, AI), factor/smart beta, direct indexing, active ETFs. Product proliferation seeking differentiation.