ETFs and Mutual Funds

When authorized participants create ETF shares, they typically deliver a basket of securities to the fund in exchange for newly issued ETF shares. The AP, not the fund’s existing shareholders, generally bears the costs of sourcing and delivering that basket, including underlying bid-ask spreads, market impact, financing, hedging, and any applicable creation fees. Those costs are then reflected in the economics of ETF trading. APs and market makers will not create or redeem shares unless the expected arbitrage opportunity compensates them for those frictions. As a result, creation/redemption costs help determine the ETF’s arbitrage band and may be reflected in premiums or discounts to NAV and in the bid-ask spread quoted on exchange. So when investors buy or sell ETF shares in the secondary market, they often pay these trading frictions indirectly through the ETF’s bid-ask spread or execution price. This structure helps protect long-term shareholders from the dilution that can occur in mutual funds, where shareholder flows may force the fund itself to buy or sell securities.

Beyond the expense ratio, ETFs incur real trading costs. These include brokerage commissions when buying or selling securities, bid-ask spreads paid on every trade, exchange fees, and regulatory transaction fees. For funds that rebalance frequently or hold less liquid securities, these costs add up. While they don't appear in the expense ratio, they directly reduce fund returns. Smart investors look beyond the published fee to understand the total cost of implementation.

Absolutely. While the create-redeem process handles much of the fund's flow in-kind, ETFs still trade securities regularly. They rebalance portfolios, reinvest dividends, manage cash flows, and adjust holdings when index methodologies change. Each trade incurs bid-ask spreads, commissions, and market impact costs. The in-kind mechanism reduces transaction costs significantly compared to mutual funds, but it doesn't eliminate them. Every portfolio change still comes with a price tag that impacts returns.

ETFs gain their tax advantage primarily through the creation-redemption process. When investors buy or sell ETF shares, authorized participants exchange baskets of securities directly with the fund—transferring shares in-kind rather than selling them. This avoids triggering capital gains inside the fund, and so it becomes very unlikely that an ETF will distribute capital gains to ETF shareholders.

Now, ETFs still distribute ordinary income from dividends and interest, just like mutual funds. But they rarely pass through capital gains.

There's also a lesser-known strategy becoming more popular in recent years: seeding an ETF through a 351 exchange.

In a 351 exchange, investors can contribute appreciated securities at fund launch in a tax-deferred manner. This creates opportunities for tax-efficient diversification or adjustments to exposures.

While both ETFs and mutual funds pool investor money into diversified portfolios and are both regulated by the 1940 Act, they work quite differently. Think of an ETF as a special type of mutual fund.

ETFs trade on exchanges throughout the day at prices determined by intraday supply and demand, while mutual funds transact once daily for all buyers and sellers at a single price called the net asset value, or NAV. The NAV is calculated by the fund accountant after market close by valuing all the underlying securities in the fund.

One of the biggest differences is tax efficiency. ETFs use an in-kind creation and redemption process to handle flows, which typically avoids triggering capital gains distributions to ETF shareholders. Open-ended mutual funds, on the other hand, typically manage flows using cash and on-market trading, which often distributes taxable gains to shareholders each year—even if the shareholder didn't sell a single share. This structural advantage makes ETFs particularly attractive for long-term taxable investors.

An ETF, or exchange-traded fund, is an investment vehicle that holds a basket of securities—like stocks or bonds—and trades on an exchange throughout the day, just like a stock. Unlike mutual funds, which price once at the end of each trading day, ETFs offer real-time pricing and flexibility.

The first ETF was launched in 1993 by State Street Global Advisors—the SPDR S&P 500 ETF. For decades, launching a new ETF required exemptive relief from the SEC—essentially a waiver allowing the fund to operate in ways that technically violated provisions of the Investment Company Act of 1940. ETFs didn't fit neatly into regulations designed for mutual funds, so each sponsor had to individually petition the SEC.

In 2019, the SEC's new ETF Rule eliminated the need for individual exemptive relief by creating a standardized regulatory framework specifically for ETFs. This streamlined approval and opened the door for more active management, customized approaches, and specialized portfolios—transforming ETFs into versatile tools for modern investors.