You’re probably familiar with mutual funds. They are arguably the most common type of investment choice for 401(k) and other retirement accounts. But ever since the first exchange-traded fund (ETF) appeared in 1993, investments into ETFs have been steadily overtaking those into traditional mutual funds. Why is this happening? Are ETFs better than mutual funds?

First let’s explore how ETFs work. Like traditional mutual funds, ETFs represent a basket of assets such as stocks or bonds. Unlike mutual funds, investors cannot buy ETF shares directly from the investment companies that offer them. Instead investors must buy ETFs from other investors on the secondary markets, just like stocks. That has several implications: (1) you can buy an ETF anytime during the trading day, unlike a mutual fund, which can only be bought at the end of the day after its net asset value (NAV) has been calculated; and (2) during periods of high demand, the prices of ETFs can exceed the actual net asset value (NAV) of their underlying assets, and vice-versa when demand is weak.

Since buyers generally do not want to pay more than an ETF is worth, something is needed to keep the price close to the ETF’s NAV. The solution is to allow certain financial institutions known as authorized participants (APs) the ability to swap with the ETF issuer blocks of ETF shares (called creation units) for the underlying securities. This approach gives the issuer an arbitrage mechanism that tends to minimize the potential deviation between the market price and the NAV of the ETF’s shares. If there is strong investor demand for an ETF, its share price will temporarily rise above its NAV per share, giving APs an incentive to purchase the underlying securities in the secondary market and trade them for additional creation units from the ETF issuer (since the creation units are currently worth more than its holdings). The additional supply of ETF shares the AP acquired from the issuer is then sold in the secondary markets, which reduces the ETF price per share, consequently eliminating the premium over NAV. A reverse process applies when there is weak demand for an ETF and its shares trade at a discount from NAV (the AP buys ETF shares from other investors and swaps them with the ETF issuer for the underlying securities).

One of the key advantages of an ETF comes from the swapping capability described above. By swapping out underlying securities with the highest embedded gains for ETF shares whenever needed, the ETF issuer can defer some of the taxable distributions that mutual funds  ordinarily pass on to shareowners at the end of each year. This tax deferral benefit can be significant depending on the type of ETF and the number of years held.

On the downside, when ETFs are thinly traded, they face the same problem as individual stocks. The spread between the bid price (the highest price a buyer is willing to pay) and the ask price (the lowest price a seller is willing to accept) can be high. This adds to the cost of purchasing or redeeming shares. Mutual funds do not have this problem since the fund company creates or sells shares at the end of each trading day exactly at NAV.

Another difference is that certain mutual funds may have different classes, each with different expense ratios, targeted for different types of investors. Each ETF has only one expense ratio.

Unless you’re a day trader, the fact that you can purchase ETFs at any time during the day is not necessarily a benefit in my opinion. In fact, the time of day at which you make your trade can have a big impact on the bid/ask spread described above.

The greatest benefit to investors of either type of fund is the diversification they bring to different asset classes. If you’re planning to buy and hold a fund in a taxable account, ETFs are probably the better choice as long as you stick to higher-volume ETFs and pay close attention to trading costs.

(PERIGON is a registered investment adviser. More information about the firm can be found in its Form ADV Part 2, which is available upon request by calling 877-977-2555 or by emailing compliance@perigonwealth.com).