What is an ETF?

exchange traded funds

exchange traded fundsYou may have been watching Mad Money or read an article in the Journal and come across the term ETF.  That guy on the train was raving about them as the next big thing in investments.  They are mentioned in a lot of articles and books, and you will continue to hear about them as their popularity grows. But…

What exactly is an Exchange Traded Fund?

So to clear things up and avoid any confusion, an ETF, or exchange traded fund, is a security that tracks an index, a commodity, bonds, or a basket of assets like an index fund. You’re probably thinking, well isn’t that just like the mutual funds that I have in my 401(k)?  Sort of, but unlike mutual funds which trades at the close of the trading day, an ETF trades more like a stock on a stock exchange which can be traded multiple times throughout a trading day. The price of an ETF changes throughout the day as they are bought and sold on the exchanges. And they typically have higher daily liquidity and lower fees than mutual funds, which makes them an attractive alternative for investors.

The Make Up of an Exchange Traded Fund (ETF)

An ETF is a fund that owns the underlying assets, which could be shares of stock, bonds, oil futures, forex, etc. and divides ownership of those assets into individual shares. If you own an ETF, you do not directly own or have any direct claim to the underlying investments in the fund.  You indirectly own these assets.

Owning ETF shares entitles you to a portion of the profits, or dividends paid, and you may get residual value in case the fund is liquidated. This ownership can easily be bought, sold just like shares of stock, since they are traded on public stock exchanges.

Advantages of ETF’s

Many financial experts love using exchange traded funds because of their low costs and liquidity.  Investing in ETF’s gives the broad based diversification of an index fund as well as the ability to do things you could traditionally do only with stocks, like sell short, buy on margin and purchase as little as one share. Another huge advantage is that the expense ratios for most ETFs are much lower than the average mutual fund. Although, when you buy and sell ETFs, you have to pay the same commission to your broker that you’d pay on any regular order.

Popular Exchanged Traded Funds

ETF’s are popular because they allow individual investors to invest in the market with more liquidity and less fees.  They are also able to invest in whole sectors or indexes fairly seamlessly. One of the most widely known and traded ETFs tracks the Standard and Poor’s 500 Index, called the Spider (SPDR), and trades under the ticker SPY.

The QQQ tracks the Nasdaq 100

DIA tracks the Dow Jones Industrial Average.

Sector ETFs exist which track individual industries such as energy companies (XLE), financial companies (XLF), Real Estate Investment Trust’s REITs (IYR), and there are many many more sector ETF’s out there.

Commodity ETFs track commodity prices on crude oil (USO), gold (GLD), silver (SLV), and natural gas (UNG) and others.

The versatility of ETF’s allow you to invest in just about anything, from certain sectors, to particular industries, to master limited partnerships.  Check with your broker to find out additional details about fees and fund construction.