Operations for any investment fund are largely the same – investment decisions, reconciliation to the custodian, accurate reporting to shareholders – but several nuances and additional levels of oversight are needed for registered funds. Among registered funds the operational processes are sometimes unique to the structure.
Mutual fund – Shares may be either purchased directly from the mutual fund company, or directed trade through a brokerage account with a broker dealer. Orders received are priced at the net asset value calculated as of the close of the New York Stock Exchange, typically.
ETF – Shares are purchased through a broker dealer on a listed exchange. Shares are priced on a bid/ask basis by market makers continuously through the trading day.
Mutual funds settle on a cash basis, either directly with the mutual fund company transfer agent, or electronically from your broker dealer to the mutual fund, or the reverse for a redemption.
ETF shares are issued by and repurchased by Authorized Participants (“AP”). APs are broker dealers willing to provide a bid/ask market for a particular ETF. APs sell shares short to satisfy a shareholder purchase transaction. To cover the short, APs will then create a “basket” of the securities held by the ETF and deliver those securities to the ETF in exchange for shares in the ETF.
Net asset value calculation
Mutual funds are valued once per day using the closing price of each security held by the fund, applying accrued income and expenses, pending transactions and any other relevant activity. The pricing is typically as of 4pm New York time, although some bond and money market funds price earlier in the day to accommodate transactions.
ETFs are valued electronically every few seconds using a technique known as indicative optimized portfolio value (“IOPV”). Every night an estimated fund value is calculated using the securities in the portfolio and all accruals. During the next market trading day, an estimated value of the ETF is calculated every few seconds and made available to market makers and APs for the ETF. It is off of this estimated value that each AP sets the bid/ask price at which they agree to either sell or purchase shares from the shareholder.
Mutual funds must be custodied by a bank, or if not custodied at a bank must be subject to three audits per year, two of which are surprise. Due to this expense, almost all mutual fund assets are held in custody at a bank. Although the number of banks offering custody services is less than twenty years ago due to both consolidation and operational requirements, any bank with trust powers can in theory serve as custodian for a mutual fund.
ETFs present a different layer of issues, and as a result there are few banks set up to serve as custodian for ETFs. Because shareholder transactions are settled by transfer of securities (in most cases) rather than a straight cash settlement, the custodian for an ETF must have the ability to combine its operations as a transfer agent and custodian into a single process. ON the surface this may seem to be a straightforward issue, but operationally it is not. A few reasons why will be outlined in the next topic.
From the SEC website: Transfer agents record changes of ownership, maintain the issuer’s security holder records, cancel and issue certificates, and distribute dividends. Because transfer agents stand between issuing companies and security holders, efficient transfer agent operations are critical to the successful completion of secondary trades.
Although is there are very few transfer agents in the U.S. (Nottingham is the only registered transfer agent authorized to handle mutual fund transactions in the Southeast), some mutual funds actually serve as their own transfer agent with internal personnel, systems and procedures.
Since mutual fund shares settle in cash, this is entirely possible, with the excellent software and systems available today
ETFs simply cannot be handled with the same ease, due largely to the complexity of exchanging ETF fund shares for securities. APs initiate settlement of ETF shares, to either cover their short or to deliver shares back to the ETF after a shareholder sale, in “creation units”, baskets of the securities held by the ETF portfolio. To accurately record the valuation and delivery or acceptance of these shares requires down to the second coordination between the portfolio valuation and the shares being issued or redeemed.
For this reason the transfer agent and the custodian need to be the same entity for an ETF, but for most mutual funds the custodian and transfer agent are different entities.
For a mutual fund the fund accounting process is one of the most integral operations of the fund, calculating the net asset value each afternoon sets the value (NAV) at which the fund is offered to new shareholders, and at which existing shareholders may redeem.
An ETF trades on an exchange so the price of the ETF is set by the bid/ask at which APs offer the fund to the public through broker dealers. The fund accounting for an ETF, therefore, is a piece of the puzzle, but is not the end product.
Every night the ETF IOPV is valued based upon the updated portfolio securities prices. This valuation is made available electronically to the exchange on which the fund is listed and used by the APs the following market day to provide bid/ask quotes.
This is one area where mutual funds and ETFs are virtually identical. Both entities are registered investment companies governed by boards of trustees (or directors, depending on the form of organization). Both require quarterly meetings, annual audits and annual and semiannual filings.