Section 1.5

Fundamentals of Market Investing by Adam J. McKee

Mutual Funds

A mutual fund is an SEC-registered open-end investment company that pools money from many investors and invests the money in stocks, bonds, short-term money-market instruments, other securities or assets, or some combination of these investments.  The combined securities and assets the mutual fund owns are known as its portfolio, which is managed by an SEC-registered investment adviser.  Each mutual fund share represents an investor’s proportionate ownership of the mutual fund’s portfolio and the income the portfolio generates.

Investors in mutual funds can buy their shares from (and sell their shares to) the mutual funds themselves.  Your broker will handle all of this for you, so the difference is mostly irrelevant.  Mutual fund shares, then, can be purchased from the fund directly or through investment firms (like the one that runs your 401(k) for your employer).  Mutual funds are required by law to price their shares each business day, and they typically do so after the major U.S. exchanges close.  This price—the per-share value of the mutual fund’s assets minus its liabilities—is called the NAV or net asset value.  (This aftermarket pricing is hugely annoying to those of us who trade stocks where prices update in real time—we are into instant gratification!)

Mutual funds must sell and redeem their shares at the NAV that is calculated after the investor places a purchase or redemption order.  This means that, when an investor puts in a purchase order for mutual fund shares during the day, the investor will not know what the purchase price is until the next NAV is calculated.  Mutual fund managers and brokers alike do not want you trading these securities, and they put rules in place to make trading them slow enough that timing is impossible in the short term.

Like mutual funds, ETFs (Exchange Traded Funds) are SEC-registered investment companies that offer investors a way to pool their money in a fund that makes investments in stocks, bonds, other assets or some combination of these investments and, in return, to receive an interest in that investment pool.  Unlike mutual funds, however, ETFs do not sell individual shares directly to or redeem their individual shares directly from retail investors.  Instead, ETF shares are traded throughout the day on national stock exchanges and at market prices that may or may not be the same as the NAV of the shares.

ETF sponsors enter into contractual relationships with one or more Authorized Participants—financial institutions which are typically large broker-dealers.  Usually, only Authorized Participants purchase and redeem shares directly from the ETF.  Also, they can do so just in large blocks (e.g., 50,000 ETF shares) commonly called creation units, and they typically “pay” for the creation units in an in-kind exchange with a group or basket of securities and other assets that generally mirrors the ETF’s portfolio.

Once an Authorized Participant receives the block of ETF shares, the Authorized Participant may sell the ETF shares in the secondary market to investors.  An ETF share is trading at a premium when its market price is higher than the value of its underlying holdings.  An ETF share is trading at a discount when its market price is lower than the cost of its underlying holdings.  A history of the end-of-day premiums and discounts that an ETF experiences—i.e., its NAV per share compared to its closing market price per share—can usually be found on the website of the ETF or its sponsor.  Like a mutual fund, an ETF must calculate its NAV at least once every day.

The bottom line for the retail investor is that ETFs trade like stocks, and in practice, you cannot tell them apart from common stocks.

Exchange Traded Products (ETPs)

 ETFs are just one type of investment within a broader category of financial products called exchange-traded products (ETPs).  ETPs constitute a diverse class of financial products that seek to provide investors with exposure to financial instruments, financial benchmarks, or investment strategies across a wide range of asset classes.  ETP trading occurs on national securities exchanges and other secondary markets, making ETPs widely available to market participants including individual investors.

Other types of ETPs include exchange-traded commodity funds and exchange-traded notes (ETNs).  Exchange-traded commodity funds are structured as trusts or partnerships that physically hold a precious metal or that hold a portfolio of futures or other derivatives contracts on specific commodities or currencies.  ETNs are secured debt obligations of financial institutions that trade on a securities exchange.  ETN payment terms are linked to the performance of a reference index or benchmark, representing the ETN’s investment objective.  ETNs are complex, involve many risks for interested investors, and can result in the loss of the entire investment.

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