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|This article is a part of Wikinvest's Personal Finance section and Guide to Investing. Please contribute or edit to improve it.|
This page is about Exchange Traded Funds. For the fund with ticker symbol ETF, see the page on Emerging Markets Telecommunications Fund (ETF)
An exchange traded fund (ETF) is an investment product - similar to a mutual fund - that trades on a stock exchange. Most ETFs track major stock indices or industry sub-sectors, which allows investors to get exposure to either the entire market or specific sectors with a single purchase. Unlike a mutual fund, an ETF's holdings - the investments it makes - are always known (its components are simply the weighted components of the index it tracks).
While some mutual funds often aim to "beat" the market or the sector they use as a benchmark, ETFs are typically designed to provide investors with the same performance of the stated benchmark (whether good or bad). Because mutual funds seek to out perform their benchmark, they are described as being "actively managed" (the portfolio managers will make buying and selling decisions based on their views of particular securities in the benchmark), whereas ETFs use "passive management".
As a result, ETFs often charge lower fees than mutual funds, and can be inexpensive ways for investors to invest in the market as a whole or specific sub-sectors. ETFs also have lower expense ratios because they are not actively managed. In most cases, this results in lower management fees and lower turnover costs.
Trading Differences Between ETFs and Mutual Funds
There are some other mechanical differences between mutual funds and ETFs with regards to how they are traded. Mutual funds are quoted shortly after the end of each trading session (and only get one NAV price per day), and typically can't be traded intra-day (buying in the morning, selling in the afternoon). On the other hand, ETFs, however, can be traded intra-day, and some can also be traded in the pre-market and after-hours sessions (note - some ETFs trade 15 minutes beyond normal market hours).
Exchange traded funds hold a pool of assets, the total value of which is divided into proportional shares which are bought and sold by investors via a stock exchange. This provides a very easy way for investors to get a specific set of equities without the overhead of purchasing each equity separately. For example, if an investor wanted to invest $1000 in all the companies in the S&P 500 index, it would be impractical for her to put such a (relatively) small amount to so many securities (she would need to split her $1000 by the weights of each stock in the S&P 500 index). However, by buying shares in an ETF that tracks the S&P 500 Index, she can easily get this exposure by purchasing one security, the ETF.
The construction method of ETFs actually creates a tax advantage for investors when compared to mutual funds. One ETF share is a proportional ownership right for a pool of assets held in the ETF; one mutual fund share is a proportional ownership right for each security in the fund. The difference is subtle, but important. If an investor buys a mutual fund for $10 a share, and sells it 6 months later for $10 a share, she could still owe capital gains on her investment. If an ETF is purchased instead, there would be no capital gains on the transaction. The reason is that the mutual fund investor owns tiny pieces of actual stocks through her fund, so when the portfolio manager buys and sells individual stocks for the fund, capital gains (and losses) can occur without a change in the fund's NAV.
Like mutual funds, ETFs are priced proportionately to the value of the underlying equities it represents. In essence, the fund takes the value of the whole pie and slices it into equal shares. Each share necessarily has the same value. However, unlike mutual funds, which calculate a Net Asset Value at the end of every day, the value of the ETF changes throughout the trading day based on supply and demand from investors; just like a stock, an ETF is subject to the Bid/Ask Spread (however the difference between "true" NAV and the quoted NAV will be very close if the ETF can be sold short).
The makeup of the 'basket' that a given ETF represents is determined when the ETF is established, and cannot change. For example, the iShares Russell 1000 Index Fund (IWB), tracks the stocks listed in the Russell 1000 Index. Plotting the two side-by-side shows a near perfect track in terms of performance.
The issuers and managers of the ETF (called sponsors) are paid a management fee from the fund itself. Though typically small, the amount of the fee varies between funds and may have a significant effect on the difference in value between the fund and it's underlying assets.
ETFs are built on sound corporate governance principles: Board of Directors, Compensated management, highly detailed recordkeeping and audit requirements.
Like Mutual Funds, ETFs are regulated by the SEC under the Investment Company Act of 1940.
(Note the bid-ask spread on your ETF at purchase: long-term investors can focus on the expense ratio alone, whereas actively trading investors may wish to consider the premium they're paying for a less-liquid ETF like VEA versus the well-known EFA)
Though commonly associated with stock indices, ETFs can hold any type of asset, including stocks, bonds, futures, currencies, or even tangible commodities such as gold bars. The variety of different "investable" assets means that ETF investors can get exposure not just to stocks, but also to entire asset classes that may otherwise be out of reach. For example, the average investor may not have the risk tolerance, capital, or trading skill to invest in oil futures, but she could easily invest in an oil etf that tracks those futures prices.