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Overview

Exchange traded funds (ETFs) are hybrid investment products that offer a unique set of characteristics. Some of their traits and advantages are shared by traditional open-end mutual funds, while other aspects make them look and operate more like individual stocks. Understanding the structure of other common investment options—including open-end mutual funds, closed-end funds and hybrid “interval” funds—can help enhance an understanding of how ETFs are structured and how they are similar or different from these other investments.

Understanding Open-end Mutual Funds, ETFs and Closed-end Funds

Open-end Mutual Funds
Open-end mutual funds are probably the most commonly recognized and widely understood investment vehicles. The very first mutual fund dates back to 1924. And today, there are thousands of mutual funds available—with varying investment objectives.

Open-end mutual funds are registered investment vehicles that collect money from different individual or institutional investors into one common investment pool. The fund manager then uses those collective investments to purchase securities (equities, fixed-income, derivatives and cash) that are combined to make up the mutual fund’s portfolio. Shares of that fund are then issued to investors in amounts that are pro-rated to the size of their investment. Such funds are dubbed “open-end” because they have the ability to continuously issue an unlimited number of overall shares as well as continuously redeem shares for cash.

Closed-end Funds
Closed-end funds date back to the 1920s. A closed-end fund has a structure similar to that of an ETF. Whether it’s an equity or fixed-income fund, closed-end funds trade in the open, secondary market via a stock exchange. Unlike open-end mutual funds, which can issue an infinite number of shares, closed-end funds have a limited number of shares that may be purchased through an initial public offering process, similar to a stock. Once the closed-end fund’s fixed number of shares have been sold, the portfolio is assembled and a one-time closure of the portfolio takes place. No further shares can be sold directly by the sponsor to investors. The closed-end fund then begins trading in the open market on a designated exchange, just as a stock would. Like an ETF, to redeem (or purchase) shares of a closed-end fund, investors must obtain the assistance of a full-service or discount broker or other financial intermediary to execute the transaction in the secondary marketplace.

ETFs
ETFs are also registered investment vehicles, but they have a shorter history. The very first ETF debuted in 1992. Individual or institutional investors cannot buy (or redeem) shares directly from an ETF provider. Instead, an ETF’s life cycle must include an Authorized Participant (AP), typically a large broker/dealer or institution, who essentially creates or “makes” a market for an ETF. An AP purchases or borrows the underlying stocks, which are then bundled together into a basket of stocks or “creation units.” Creation units may then be exchanged by the AP, via an in-kind transaction, for an equivalent amount in value of shares of the ETF. Once the AP obtains those ETF shares, it is free to sell them on the open market to individual investors. Investors only become involved in the direct purchase or sale of ETF shares once creation units are in place and the ETF has begun trading on a stock exchange.

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