Exchange traded funds (ETFs) are gunning for the mutual fund throne.

But as investors try to figure out what’s right for them, it’s important that they know what the differences between the various types of funds happen to be, reports Cathy Pareto for Investopedia.

Mutual funds generally fall into two categories:

  • Open-ended fund: These are the most common, as they dominate in both assets and volume traded. Purchases and sales take place directly between the investors and the fund company. The value of the shares are not affected by the number outstanding.
  • Closed-end fund: These have a set number of shares and do not issue more shares as demand grows. Prices are driven by demand, not the NAV.

ETFs come in three forms:

  • Exchange traded open-end index mutual fund: Dividends are reinvested on the day of receipt and paid to shareholders in cash each quarter. Securities lending is allowed and derivatives may be used in the fund.
  • Exchange traded unit investment trust (UIT): These must attempt to fully replicate their specific indexes, limit investments in a single issue to 25% or less and sets weighting limits for diversified and non-diversified funds. They don’t automatically reinvest, and pay cash dividends quarterly. An example of this is the PowerShares QQQ (QQQQ).
  • Exchange traded grantor trust: It looks like a closed-end fund, but the investor owns the underlying shares in the companies and has the same voting rights as a shareholder. Dividends are paid directly to shareholders, not reinvested. An example of this kind of ETF are holding company depositary receipts (HOLDRs).

Among the advantages ETFs have over mutual funds are:

  • Greater trading flexibility, since they trade all day just like a stock.
  • Fees are generally lower. ETF fees range from 0.07% to 1.25%, while mutual fund fees range from 0.5% to more than 10%.
  • They have tax advantages for investors, as passively managed funds tend to realize fewer capital gains than actively managed mutual funds.

The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.