Talking Shop with David Koch: What is a Stock? Part 5

By David Koch, CFP®, AIF®, CFA, Senior Wealth Advisor

”What is a Stock?” is a 5-part piece from our Advisor Insights series Talking Shop with David Koch. If you missed it, read Part 4 – Trading Strategies: Dollar Cost Averaging, Rebalancing and the Moving Daily Average

Pooled investment vehicles like mutual funds and exchange-traded funds (ETFs) are used to simplify diversification. They allow an investor to make one transaction and then have professionals do the work and make multiple transactions on their behalf. Believe it or not, funds like this go back at least as far as the 1770s in Amsterdam, when a Dutchman created a trust named Eendragt Maakt Magt, meaning “unity creates strength.” Pooled vehicles have been used in the United States as early as the 1890s, and the first open-end mutual fund with redeemable shares was created in the U.S. in 1924 as the Massachusetts Investors Trust, which still operates today and is managed by MFS Investment Management.

After the Wall Street crash of 1929, Congress passed a series of acts regulating the securities markets. These included the Securities Act of 1933; the Securities and Exchange Act of 1934, which created the Securities and Exchange Commission (SEC); the Revenue Act of 1936, which established guidelines for the taxation of mutual funds; and the Investment Company Act of 1940 – also colloquially called The 1940 Act. These new regulations encouraged the development of mutual funds, especially open-end mutual funds.

Mutual funds – open-end and closed-end

Closed-end funds have a fixed number of shares, which are traded on the open market. Initially, money comes in from investors and the underlying investments are purchased; then the shares of the fund are traded among other investors. Think of these like stocks: A company IPOs and issues shares and then the shares are traded among investors. With closed-end funds, the number of shares rarely changes. The value of the underlying investments may be more or less than what people are willing to pay for them separately (again, like a stock). The difference in price between what the basket of investments is worth and what investors pay is called the premium (or discount). More on that later.

This contrasts with an open-end fund, in which shares are created and dissolved (also called “redeemed”) each day. When an investor buys a share of a closed-end fund, for comparison, they are buying it from another investor who wishes to sell their specific share.

When an investor buys a share of an open-end fund, the fund company purchases more of the underlying investments and creates a new share for the new investor. When someone wants to sell a share of an open-end fund, the fund manager sells some of the underlying investments, gives them cash, and the share is dissolved. Essentially, cash and the shares of an open-end fund are traded between the fund company and the investor, not between two investors (like stocks and closed-end funds).

Open-end mutual funds trade once each day at the close of the market. You may notice this if you look at your brokerage account during market hours and see that your S&P 500 mutual fund has a daily return different from what you may be seeing on TV. Your mutual fund has not repriced yet and is likely still reflecting yesterday’s market movement. Mutual funds reprice once per day and that’s usually in the late afternoon.

Open-end funds are by far the more common type of mutual fund. There are about 100x more dollars invested in open-end funds than closed-end funds in the U.S. Because of this, most people are only familiar with open-end funds. I may have added some confusion in order to be accurate, but unless specified, most investors will simply refer to the open-end type of mutual fund when talking about mutual funds in general.

Exchange Traded Funds (ETFs)

Quick technical note: An ETF is one version of an Exchange Traded Product (ETP). ETPs also include Exchange Traded Notes (ETNs), which are unsecured debt instruments of the issuer, not a basket of underlying investments like an ETF. The term ETF, however, has gained far more usage in modern vernacular, and so while they are in many ways very different, most investors simply use the term “ETF” as a substitute for all ETPs.

An ETF is a fund that is traded on an exchange, like the NYSE or the Nasdaq. What that means is that most shares are traded among other investors, “exchanged” throughout the day. When a big-enough buy or sell order comes in though, shares will be created or destroyed through what is called an authorized participant (AP). I’m getting a little technical here, but if you tell someone at a cocktail party, “there’s a creation process with ETFs through an authorized participant,” you may earn some points with the geeks in the room.

There are some tax advantages to ETFs as well. Without getting too complicated, the AP pays the highest tax rates no matter what and so the ETF can push the worst lots (from a tax perspective) onto the AP and keep the most tax-advantageous lots. Mutual funds are required to push out capital gains to their shareholders on an annual basis, but ETFs are able to push most of these onto the AP. This enables ETFs to push capital gain distributions out far less frequently.

This makes ETFs a kind of hybrid between a mutual fund and a stock. And like both mutual funds and stocks, they’re regulated by the SEC. In fact, since ETFs are traded like stocks on stock exchanges throughout the day, many finance professionals just call them stocks. Broker-dealers like Fidelity and Schwab treat them similarly as well in that stocks and ETFs have no trading commissions, but mutual funds still do. That’s one big difference right there.

The fact that ETFs are traded throughout the day means that they’re priced intraday as well: An ETF that tracks the Russell 2000 index of small cap stocks, for example, should reflect the pricing of the Russell 2000 index throughout the day. A mutual fund that tracks the Russell 2000 will reprice just once, later in the day, after the market closes.

There are some common misconceptions about ETFs – that they’re all passive index funds and they’re less expensive than mutual funds. This is because the first wave of ETFs issued were index funds, like the oldest ETF, SPY, which was created in 1993 and tracks the S&P 500. But since then, and especially in the last decade, ETFs have been created that are just as actively traded, expensive, and exotic as anything that’s been put into a mutual fund. Their universe of underlying investments has expanded along with their use overall.

Other costs associated with ETFs

Many brokers no longer charge a trading fee to trade ETFs, but they still charge to trade mutual funds. Mutual funds can be bought directly from the specific fund company that manages the fund (like buying Vanguard funds from Vanguard, or Franklin Templeton funds from Franklin Templeton), but this is becoming less and less common. It is far easier for investors to have everything in one custodial account like at Fidelity or at Schwab.

ETFs may not have an explicit commission charged by the custodian, but that doesn’t mean they trade for free. Many investors don’t realize that there are two prices they should pay attention to when buying or selling an ETF: the bid price (the price at which you can sell) and the ask price (the price at which you can buy). The difference between the two is called the spread.

Let’s imagine an ETF with a bid of $49.90 and an ask of $50.10. Someone might quote the price at $50 because that’s halfway between the two. This is called the midprice. But if you were to buy some shares you would pay $50.10 per share and if you were to sell some shares you would only get $49.90. What’s going on here? Well, there are people who transact in stocks and ETFs professionally. If the quoted price is $50, they’re going to want to make a little money.

About bid-ask spreads

A stock or ETF that isn’t traded frequently will have a wider spread than a stock that’s traded more frequently. Where does the spread come from? A rough analogy is the used car marketplace. Think about a used car dealer that takes in a 20-year-old Honda Civic. They’ll give you $4500 for it knowing that they can sell it tomorrow for $5000 and make $500. Next someone comes in with a 20-year-old Ferrari; nice car, but the dealer may not find a buyer for six months. They think they can get $20,000 for it, but maybe not. In order for them to take that risk, they only offer to pay $15,000.

The dealer is looking for a 25% margin – like a spread – on the Ferrari rather than a 10% margin on the Civic because Ferraris are not traded as often. They’re taking the risk that they can’t unload it for some time and that they won’t be able to get $20,000 for it when they do find a buyer.

Premiums and discounts

Since an ETF if often traded among investors, sometimes people pay more for the ETF than the value of all the underlying investments it holds. This is called a premium. Sometimes an ETF can be purchased for less than the value of all the investments it holds. In this case, the seller would be selling at a discount.

Think about an ETF that owns a bunch of airlines, like the ticker JETS. If someone wanted to buy a bunch of airlines but would rather buy one ETF instead of going out and buying all of them individually, this ETF would be pretty convenient. If a bunch of other people wanted to as well, they may start exchanging shares of the ETF at more than its underlying value, also called Net Asset Value (NAV).

On the other hand, if everyone wanted to sell their shares in their Nigerian stock ETF (such as the ticker NGE), those shares might start being traded at a discount to this ETF’s underlying investments – its NAV. Investors may end up paying more (or less) for the ETF than what the value of what the ETF holds is worth. This is what’s known as the premium or discount – and you can look these up (along with the bid-ask spread) on most finance websites.

These premiums and discounts are usually small, however – less than 0.5% – because a large investor could buy the ETF and then ask the AP to exchange it for the underlying investments (or vice versa). Nonetheless, larger pricing disparities occasionally do happen.

In contrast, one advantage to a mutual fund is they always trade at their NAV. Since shares are created and redeemed between shareholders and the fund company, not among traders buying and selling shares amongst themselves, the investor in the fund gets exactly what the underlying investments inside it are worth.

Historically, ETFs were mostly passive index funds and so they have a reputation for being low cost. This is no longer the case. They can be as expensive and exotic as any mutual fund.

Wrapping up

A few final points. Mutual funds often have different share classes for the same underlying fund. A share class might have a front-end commission that’s paid to the broker (an “A-share”) or a lower expense ratio for a larger minimum (like an “I-share” with a minimum $1,000,000 investment). At times it can seem like alphabet soup with the share classes of mutual funds. An ETF, like a stock, has none of these variations.

ETFs are traded throughout the day, and while many big brokers don’t charge to trade them, buyers and sellers pay a spread, and shares are often bought and sold at a premium or discount to what the underlying holdings are worth. Mutual funds are traded once each day at the close the market. While they still have a fee attached to trade through a broker, investors can transact directly with the fund company when the shares are created or redeemed – and they always get the NAV.

Which is better? As you’re likely well aware, that depends on what your goals are. Looking for more information? Ask one of our friendly advisors at: Contact Us

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Disclaimer: 

The views contained herein are not to be taken as an advice or recommendation to buy or sell any investment. Any forecasts, figures, opinions or investment techniques and strategies set out are for information purposes only, based on certain assumptions and current market conditions and are subject to change without previous notice. This material should not be relied upon by you in evaluating the merits of investing in any securities or products mentioned herein. In addition, the Investor should make an independent assessment of the legal, regulatory, tax, credit, and accounting and determine, together with their own professional advisers if any of the investments mentioned herein are suitable to their personal goals. Investors should ensure that they obtain all available relevant information before making any investment.