What are Exchange Traded Funds (ETF)

by Investing School on March 30, 2009

Exchange Traded Funds (ETF) might be one of the most innovative investment products of recent times. These funds, unlike mutual funds, trade in the stock market and offer retail investors an simple way to invest in otherwise complex investments.

While only authorized entities can make transactions directly with the fund manager, everyone who have access to the stock market (usually through a stock broker) can buy or sell shares of ETFs.

Exchange Traded Funds Characteristics and Advantages

Highly Liquid – ETFs are traded on the open market and therefore can be bought or sold throughout the day when the stock exchanges are open. This is much different than mutual funds where an investor can only buy or sell at the end of each business day.

Costs – Almost all stock brokers treat ETF like a stock, so commission and fees are naturally lower. For instances, it’s not uncommon to be able to buy a ETF for less than $5 per trade (some brokers even offer free trades), while mutual funds may cost you $20 or more per transaction.

Reduced Taxes – Mutual funds investors may need to file a realized gain even if the mutual fund lost value during the past year. This is because the fund must distribute the gains to shareholders whenever transactions of any securities it owns are sold at a gain. Since ETF investors are shareholders of the ETF itself (and not shareholders of the underlying securities that the ETF holds), gains and losses aren’t realized until they sell shares of the ETF.

Flexibility – Other benefits of ETFs are due to the stock like features. As ETFs are traded on the open market, strategies such as buying on margin, short selling, and conditional orders can be applied.

What ETFs Mean for Us

For retail investors, exchange traded funds are an straightforward way to invest in complex securities. However, most ETFs use complex algorithms and derivatives to track the underlying investments which is never the same as owning the actual securities. While the margin of error may be small (typically less than 2%), it is important to understand how the ETFs tracks those particular investments before committing your capital.

For example, a very popular ETF is the United States Oil Fund LP (USO) which tracks the price of the West Texas Intermediate light, sweet crude oil. However, most people mistakenly believe that the fund tracks the widely reported price of the closest delivery of a barrel of oil. This is simply not 100% correct, and investors therefore are usually confused when the results don’t perform according to plan.

The Bottom Line – Make sure you understand the investment you are purchasing, and exchange traded funds can be a great way to build your investment portfolio.

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{ 1 comment… read it below or add one }

Jimmy March 30, 2009 at 9:31 pm

Exchange traded funds are a great way to diversify your portfolio. I used to hire a financial planner to help me manage my wealth because he had access to complex investments but with ETFs, I can pretty much do everything myself. I may not be as in tune with the market as him, but with a 2% management fee from my advisor every year and another 2% from the funds that he picks, a low cost ETF has a lot of room to underperform the other active funds.


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