Exchange-traded funds (or ETFs) are a type of mutual fund. Essentially, ETFs are mutual funds that trade on the stock market. As such, they offer features of a mutual fund in a stock-like instrument.

Just like mutual funds, ETFs represent a collection of underlying securities or stocks. Typically, ETFs try to replicate an index such as the S&P 500, Dow Jones Industrial Average (DJIA), Russell 2000, MSCI EAFE , and so on. Presently, nearly all ETFs are passively managed. That is, unlike many mutual funds, the firm managing the ETF does not actively add or remove stocks (unless the index being tracked changes). The first, and most widely held (as of November 2004) ETF is the S&P 500 "Spider" (SPY) - the nickname is a pronunciation of the fund's acronym, SPDR, which stands for Standard and Poor's Depositary Receipt. Also popular and well known are the "qube" (QQQQ), which tracks the NASDAQ 100 Index, and the "Diamond" (DIA), which tracks the Dow Jones Industrial Average.

There are over one hundred ETFs traded on U.S. stock exchanges, with more in other countries. ETFs have been gaining popularity ever since they were introduced by the American Stock Exchange in the mid 1990s, beginning with SPY in 1993. ETFs are attractive to investors because they offer the diversification of mutual funds with the features of a stock. The popularity is likely to increase as new and more innovative ETFs are introduced.

Today ETFs present a viable alternative investment option from index funds and mutual funds. There are many available ETFs that resemble all kind of indexes (such as large-cap, mid-cap, small-cap, etc), specialties (such as value and growth), industries, countries, and even commodities (while commodity funds like Gold Shares are technically not ETFs, they trade like ETFs). And more are being developed for the future. There are discussions of ETFs for other indices and commodities, as well as actively managed ETFs.

Since ETFs evolved from the concept of index funds, they typically have very low expense ratios compared to actively managed mutual funds. They also have lower turnover ratio , which is more tax-favorable .

ETFs vs. (Open-End) Mutual Funds

There are many advantages to ETFs, and these advantages will likely increase as ETFs are improved. Most ETFs have a lower MER (management expense ratio) than comparable mutual funds. Mutual funds generally charge 1% to 3% while ETFs are almost always in the 0.2% to 1% range. Over the long term, these cost differences can compound into a noticeable difference.

ETFs are also more tax-efficient than mutual funds. Mutual funds can trigger capital gains distributions when large number of holders redeem their shares, even for those investors that keep their shares. In contrast, ETFs are not redeemed by holders (instead, holders simply sell their ETF on the stock market, as they would a stock), so that investors generally only realize capital gains when they sell their own shares.

Perhaps the most important, although subtle, benefit of an ETF is the stock-like features offered. Since ETFs trade on the market, investors can carry out trades similar to a stock. For instance, investors can short, use a stop-loss order , buy on margin, and invest as much or as little money as they wish (there is no minimum investment requirement). Mutual funds do not offer those features. For example, an investor cannot place a stop loss order on a mutual fund, and purchases and sales of mutual fund shares only occur at the closing price, not throughout the day as with an ETF.

ETFs also have some disadvantages when compared with (open-end) mutual funds. One potential disadvantage stems from the fact that many mutual funds are actively managed. Mutual fund managers can seek out undervalued and profitable firms whereas ETFs typically just track an index. (Some studies have shown that most mutual fund managers do not beat a passive index. However, professional mutual fund managers may be better for small-cap, foreign, and similar areas).

Another advantage of mutual funds is that they have lower costs if you only invest a little bit of money, or invest small monthly or quarterly amounts. Since ETFs are traded on the stock market, every trade has commission costs. Many mutual funds do not have such costs. If an investor likes to invest, say, $100 or $500 every month, mutual funds will cost less.

External Links

• ETF Connect provides details about ETFs and closed-end funds.
• ETF Zone provides commentary related to the ETF industry in USA.
• Morningstar's ETF section contains information about the various ETFs.
• Exchange-Traded Funds (ETF) Center - Yahoo! Finance
• IndexUniverse is a site geared towards professional investors interested in indexes. Since ETFs generally track some index, this is an excellent site to visit if you want advanced knowledge about indexes.
• ETF List A list of exchange traded funds