From Your Perspective: Comparing mutual funds, ETFs & UITs Comparing mutual funds, ETFs & UITs Hundreds of indexes track changes in the financial markets. Some are narrow measures of a specific sector or industry, such as indexes that track clean technology or consumer goods stocks or the securities of a particular country. Others are broad gauges of overall market activity and are considered bellwethers of the health of the economy. For example, the market value change in the benchmark Standard & Poor’s 500 Index, or S&P500, which follows 500 widely held U.S. stocks in leading industries, is one of the ten components of the Index of Leading Economic Indicators, the primary measure for forecasting changes in the economy.

With the important role that indexes play in the financial markets, it’s no wonder some people think that an index might be the perfect investment. The trouble is, you can’t invest in an index. It’s a statistical calculation, not a security. And it’s not for sale. But there are some investment alternatives.

Index-based investment products, including index mutual fund, exchange traded funds (ETFs), and unit investment trusts (UITs), are all designed to mirror the performance of a stock or bond index, from the very narrowly focused to the very broad. While these investment products are each constructed differently, they share some basic characteristics that can make them attractive to investors:

Helpful hints
Because indexes aren't securities, and they aren't investments, you're likely to hear them called investment products, investment instruments, and investment vehicles. That's the same language used to describe futures and options.
Page 1 of 9




Active vs. passive investing You can trace the roots of index investing to the 1970s, when some economists began advocating the efficient market hypothesis. This theory holds that a stock’s market price accurately reflects everything that investors know about the security and that future prices can’t be predicted based on past performance. Due to what they describe as the random walk of prices, proponents of the efficient market theory believe that no investor has an advantage in predicting future prices, making it impossible to consistently outperform the market. The efficient market theory set the stage for the creation of the first index investments, which are designed to match, rather than beat, market performance.

Actively managed vs. passively managed investments

In actively managed funds, fund managers try to capitalize on market conditions, exercising trades to try to maximize profits or minimize losses. Fund investors pay for the manager’s expertise — and the research behind it — through management costs that are part of a fund’s expense ratio. The active trading that some fund managers do can also generate high turnover in a fund portfolio leading to short-term capital gains and high transaction costs.

Index funds, on the other hand, are passively managed. Securities in the fund change only when the underlying index adds or drops a security from its listings. Because index funds require little active management, they are typically cost-efficient investments and usually have lower expense ratios than actively managed funds. Plus, because index funds buy and sell investments infrequently, they tend to be tax-efficient.

Whereas the average expense ratio for actively managed mutual funds is around 1.5%, many index funds charge around 0.2% or less. This price difference means that actively managed funds must outperform their passive, index-based relatives by a considerable margin just to deliver the same results.
Not so random after all?
Efficient market theory is only one of many schools of economic thought, and many investment professionals believe that future prices can be predicted, among them technical analysts who use statistical analysis of prior performance to predict future stock behavior. Not surprisingly, they aren’t advocates of index investing.
Page 2 of 9




Index mutual funds An index mutual fund works in much the same way as any other mutual fund. The fund sells shares to investors and uses the money it raises to purchase a portfolio of investments — called the fund’s underlying securities — to meet its investment objective. Fund investors don’t own the fund’s underlying securities directly, but instead own shares of the fund, and receive earnings on its investments in the form of distributions.

Types of index funds

Most index funds are full replication funds, which means they purchase all of the securities in direct proportion to their weighting in the index. So, for instance, a full replication fund tracking the market capitalization- weighted S&P 500 would own shares in all 500 stocks, but it would own more shares of the stocks with the highest capitalizations and fewer shares of those with the smallest.

However, in some cases a fund may use computer modeling to identify representative securities in the index based on their financial characteristics and market behavior and purchase only a sample of the index. A fund might use this strategy, called optimization, if the index is very large (and therefore too expensive to fully replicate), its securities trade infrequently, or if for regulatory or other reasons full replication is impractical. An example of a fund that uses this strategy might be one managed against the Russell 2000 benchmark. With 2000 stocks in the index, it is easier and cheaper to replicate with a sampling of the stocks.

Index tracking and tracking errors

The goal of a replication fund is to produce the same returns that you would get if you owned all of the stocks in the index. But because of transactions, operations, and other costs, fund net asset values (NAV), or cost of shares, always slightly lag the returns of the underlying index. The spread between the fund NAV and the index return is called the tracking error, and the goal is to keep the spread as narrow as possible.

In fact, funds that track the same index will vary in performance on account of differences in replication technique and expense ratios. The higher the expense ratio, the lower your return will be, even when the underlying investments are the same.
Word to the wise
It’s a good idea to be on the lookout for replication funds with high expense ratios equivalent to those of actively managed funds. You probably don’t want to overpay for passive management, since fund expenses will chip away at your investment return.
Page 3 of 9




Enhanced index funds Enhanced index funds and quanititative or “quant” funds, while not replication funds, build on traditional indexing strategies and are playing an increasingly important role in many institutional and individual investors’ fund portfolios.

An enhanced index fund attempts to outperform its underlying index using a variety of strategies. For instance, the fund might seek higher returns by identifying the undervalued stocks in the index, allocating a greater portion of the fund to stronger-performing sectors, or buying derivatives on the underlying securities. These funds use traditional research and management, complex computer modeling based on quantitative investment analysis, or some combination, to select securities within the index.

Enhanced funds try to beat the index by a very small margin — from a fraction of a percent to two percentage points — since a spread wider than that maximum would classify them as actively managed funds.

While enhanced funds offer the potential for marginally higher returns than traditional replication funds, there is also the risk that they will underperform their benchmarks. Plus the expense ratios for enhanced index funds may be more in line with actively managed funds than passively managed replication funds. So if you are considering purchasing an enhanced fund, it’s smart to weigh whether the additional return you might achieve is worth the additional risk you would be taking plus the potential for added costs.
Helpful hints
One active trading technique that is index-related is to buy stocks that are about to be added to an index. Investors who use this strategy anticipate that the price of the stock will go up when fund managers are required to buy the stock to ensure their fund is in line with the new composition of the index.
Page 4 of 9




Quant funds Quant funds, also known as quantitative funds, are named for their quantitative investment style. They build on index investing principals, including a passive investment approach, computerized security selection and portfolio management, and low management costs. Quant funds use increasingly sophisticated computer modeling based on financial data such as price-to-earnings ratios, projected earnings growth, and past performance, rather than traditional research performed by securities analysts, to screen thousands of stocks and identify those that may outperform their benchmarks.

Proponents of quant funds say they take the subjective, or emotional, element out of investment decisions. However, some quant funds take a hybrid approach, using traditional managers to decide, for instance, which stocks in a portfolio to sell short for economic, regulatory, or other reasons that can’t be factored into a mathematical model.

Because so much of the security selection and portfolio management in a quant fund is computer-driven, expense ratios tend to be low. However, because of frequent trading in quant funds, they can have higher turnover ratios, which can lead to high trading costs and short-term capital gains, chipping away at fund return. It is important to weigh these factors against the additional return being generated by this type of fund to ensure that you are earning enough to offset the potentially higher tax burden.

Also, because quant funds closely guard their proprietary methodologies, there may be a lack of transparency, in some cases, regarding the specific strategies a quant fund follows, or the amount of investment risk you may be taking if you invest in one.
Helpful hints
Another approach to index investing is to buy stock index options to hedge your stock portfolio. Or you can buy or sell contracts on index-based futures, which allow you to speculate on future changes in the value of a specific index within a particular time frame. Each contract is based on a specific index, and what the contract is worth at any time before it expires is determined by a variety of factors, including investor demand. Your profit or loss depends on how the index changes within a specific time frame and the position you’ve taken on the outcome.
Page 5 of 9




What’s an exchange traded fund? Exchange traded funds (ETFs) share some characteristics with individual securities and others with mutual funds. With ETFs, you buy and sell shares in an entire portfolio of securities — sometimes called a basket of securities — the same way you buy and sell shares of a single stock. And like stocks, ETF shares are traded through a brokerage account.

The benefit of this fund structure is that you can buy and sell during the trading day, unlike a mutual fund, which can only be purchased or sold at the close of business.

But similar to a mutual fund, you own shares of the ETF rather than shares of the underlying investments. And both types of funds have a net asset value (NAV) that reflects what a single share is worth at a particular point in time.

Each ETF tracks a particular index or sector and, like an index fund, seeks to replicate its performance by owning all of the securities listed on the index. ETFs, like the indexes they track, may include several dozen, several hundred, or even several thousand securities. As with index funds, ETFs lag the underlying index by a small margin, known as the tracking error, on account of fund expenses and fees. The tracking error may also be influenced by the fact that index values are determined as of 4pm when the U.S. stock markets close, but ETF trading continues after the closing.

Creating an ETF

After receiving permission to establish an ETF from the Securities and Exchange Commission (SEC), the fund sponsor — usually a major money management firm — partners with a large broker, market maker, or other institutional investor, called the authorized participant. The authorized participant accumulates a basket of securities that matches the composition of the underlying index.

The securities are sent to a bank for safekeeping, and the fund sponsor sends the ETF shares to the authorized participant, who offers them for sale. After the initial sale, investors can buy and sell shares in the secondary market.

ETFs usually have a lower expense ratio than traditional actively managed mutual funds. The average ETF expense ratio is less than 0.30% versus over 1.00% for these mutual funds.

The cost of trading an ETF is the commission charged, similar to the commission charged when trading a share of stock. When compared to the cost of trading traditional load mutual funds this cost can also be lower.
Page 6 of 9




Open-end, UIT, or grantor trust? ETFs may be structured in a number of ways:


Fact or fiction
While they may sound like pieces in a board game, Spiders, Diamonds, and Qubes are names for the popular ETFs that track some of the best-known indexes. Spiders, which take their name from the acronym for Standard and Poor’s Depository Receipts (SPDR) , track the S&P 500. DIAMONDs are based on the Dow Jones Industrial Average (DIA). And Qubes, which track the tech-heavy Nasdaq 100 Index, are named for the ticker symbol QQQQ. Structured as Unit Investment Trusts, these are some of the most widely traded investments because they provide exposure to important parts of the market.
Page 7 of 9




What’s unique about ETFs? While ETFs are similar to index mutual funds in some ways, there are also some important differences between the two. Most of these arise from their distinctive creation and redemption process:

No cash drag: Because ETFs don’t have to redeem shares, they have no need to allocate a portion of their portfolios to cash. This helps limit the potential for cash drag, or a reduction in a fund’s performance caused by cash allocation.

Trading flexibility: ETFs trade like stocks, opening the door for a variety of trading techniques that aren’t available with mutual funds. For instance, active traders may buy on margin, sell short, and use stop and limit orders. Whereas mutual fund prices are set daily at the close of trading, ETF prices fluctuate throughout the trading day. The purchase price for an ETF can be at a premium or discount from the Net Asset Value (NAV), based on supply and demand in the marketplace.

Additionally, buyers and sellers of ETFs must cover a portion of the “bid/ask spread” — the difference between the highest price a buyer is willing to pay and the lowest price a seller is willing to accept. ETF transactions are typically conducted in the middle of the spread, meaning that, in effect, you pay half of the spread at the time you buy and half when you sell. That spread is the profit that the broker or market maker realizes on the trade.

Tax efficiency: ETFs don't have to buy and sell shares to accommodate shareholder purchases and redemptions as mutual funds do, minimizing portfolio turnover and the potential tax consequences of capital gains or losses.

And ETF managers have an additional tool for reducing taxes. That’s because the only way to redeem shares is to have an authorized participant exchange them for a basket of the securities tracked by the ETF. That’s the reverse of the way in which the shares are created.

This exchange is an in-kind trade, not a taxable transaction. In addition, the ETF is able to hand over the securities with the lowest cost basis — those that cost the fund the least to acquire. This effectively steps up the basis of the ETF’s remaining securities, reducing the potential capital gains taxes that might be triggered when the portfolio is updated to reflect a change in the composition of the underlying index.

However, while these tax savings are characteristic of large, frequently traded ETFs that track major indexes, they may not be as available with others that are more thinly traded or that are based on indexes whose composition may change frequently.
Word to the wise
Investing in an ETF within your tax-deferred retirement account limits the tax-efficiency benefits of the investment. However, ETFs may still be useful in your 401(k) or traditional IRA portfolio because they can be valuable asset allocation and diversification tools. Page 8 of 9



Choosing among index investments Index investment products may be a good way to help you allocate and diversify your portfolio. The variety of products — from broad-based index funds to quant funds to a vast array of ETFs focusing on different aspects of the market — means that you have lots of choices, whether you are just starting to invest or want to fill in some gaps in an extensive portfolio.

But you do have to comparison shop. First, there are some basic distinctions between mutual funds, ETFs, and other index investment products that you should factor into your decision-making. You may decide to stick with one type or another, or it may turn out that you purchase a variety of different types. Then there is the choice of one or more specific funds, ETFs, or UITs to suit your needs. Here are a few of the things you’ll want to consider.

Weighing the differences

While you can trade ETFs throughout the day, sell them short, or buy on margin — which you can’t do with mutual funds — you must buy and sell ETFs through a brokerage account as you would individual securities. This means commissions may add substantially to your investment costs. If you plan to trade often or use a dollar cost averaging strategy, investing fixed amounts of money on a regular schedule, brokerage commissions could have a major impact on your investment return. On the other hand, if you plan to make large individual purchases infrequently, the cost and tax efficiencies of ETFs may to work to your advantage.

While mutual funds may not offer the trading flexibility that ETFs do or track as many exotic indexes, you may find their costs are comparable to those of ETFs that track established indexes. Remember, too, that you can redeem mutual fund shares at any time at their current NAV, often without transaction costs.

It’s a good idea to talk to your financial professional to help you create a plan for including index investments in your portfolio and choosing the right mix of individual products to help you meet your goals.

  Mutual Funds Exchange traded funds
Real-time quotes No Yes
Intraday trading No Yes
Commissions or sales charges Sometimes Yes
Shareholder services Yes No
End-of-day NAV= Trading price Yes No
Commissions or sales charges to reinvest earnings Sometimes Yes
Buy on margin or sell short No Yes

Next steps
If you’re looking for an investment that combines portfolio diversification and transparency with the ability to generate regular income, you may want to consider bond unit investment trusts (UITs). If you have limited amounts of money to invest, bond UITs can let you achieve greater diversification than you could with individual securities. Also, because these UITs mature on a specific date, from one year to several decades, you can time when your principal will become available to meet anticipated future expenses, such as tuition payments.
Page 9 of 9