What is an ETF?

What is an ETF? April 27, 2012

You’ve probably heard the term “ETF” before, but what does it mean? More importantly, how does one use ETFs within their investment portfolio? Let’s explore ETFs and see if they’re right for you.

What is an ETF exactly?

An ETF is an “exchange-traded fund.” This means that it is an investment fund traded on stock exchanges. They can be traded much like stocks and can hold a variety of different assets such as:

  • Bonds,
  • Stocks,
  • and Commodities.

Why Should You Use ETFs?

ETFs are an attractive investment option for a couple of different reasons. First, ETFs have low costs making them available to less capable investors. Second, they are rather tax efficient. Third, as mentioned previously, they can be traded much like stocks easily through an online broker.

Because of these reasons, ETFs have grown in number ever since the first surviving ETF in 1993 (Standard & Poor’s Depositary Receipts (SPDR). Year after year, there are more ETFs than ever.

How Do You Use ETFs?

Let’s say that Joe likes to trade ETFs through his online broker. He has $5,000 to invest and hears that ETFs might be a good option.

Joe starts researching ETFs and finds that the natural resource market is doing well, so he invests his $5,000 in a few natural resource ETFs. He does this through his online broker and monitors these investments very closely each day.

As you can see, investing in an ETF is rather easy. If you’ve ever bought a stock online, you’ll have no problem investing in ETFs.

How are ETFs different than mutual funds?

You might be saying to yourself, “ETFs sure sound a lot like mutual funds! What’s the difference?” There are several important differences:

1. ETFs are passively managed thus lower cost.

Remember how we discussed that ETFs are low cost? That’s because they are passively managed. Mutual funds, on the other hand, are actively managed and therefore often have fees twice that of an ETF.

2. ETFs change in price throughout the day.

Like a stock, you’ll see the price of an ETF change throughout the day. Mutual funds calculate their net asset value (NAV) each day.

3. ETFs are valued based on how well the underlying asset performs.

Mutual funds are managed by a fund manager, thus the value of a mutual fund is affected by the fund manager. ETFs on the other hand are valued based on how well the underlying asset performs, leaving out the middleman (the fund manager).

The Dangers of ETFs

While there are some benefits when it comes to ETFs, there are also some dangers to be aware of:

1. ETFs have various financial goals and expert advice is needed.

Don’t think that because investing in an ETF is easy to do you should dive right in. All investors should consult a financial expert to determine if buying a specific ETF is a wise investment.

2. Some ETFs are “synthetic” in nature.

Why are some ETFs called “synthetic?” They mimic the behavior of actual ETFs by utilizing sophisticated derivatives, such as swaps. These are very complicated practices that are risky and use methods like short-selling to increase returns. Watch out, you might lose a lot of money if you pick one of these ETFs!

3. ETFs are not managed by professionals.

Most ETFs track an index automatically. Remember, they are not managed by professionals such as fund managers. Fund managers are experts who eat and sleep investments, so some may argue that without fund managers, ETFs are automated disasters waiting to happen.

Choose What’s Right For You

If you’re weary about investing in ETFs, you might want to consider Dave Ramsey’s investment advice. He recommends investing in mutual fundswith long term track records, not ETFs. But if you feel comfortable trading ETFs and like the advantage of lower fees, ETFs might be just the investment for you. Check outfor $4.95 ETF trades.

What do you think about ETFs? Leave a comment below and let’s get the conversation started!

Sources: Investopedia and Wikipedia

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  • I think ETFs are really poised to become hugely popular given how diverse the available investment options are for them. They just make it so easy to invest in just about anything. Good to stay away from those synthetic ETFs though. Too much to risk in my opinion.

  • Great topic! ETFs can be useful. However, a couple of points about your post.

    First, I have found that there are some actively managed ETFs around now – for example: State Street has 3 http://community.nasdaq.com/News/2012-04/state-street-unveils-3-actively-managed-etfs.aspx?storyid=137298.

    Also, not all mutual funds are actively managed. Vanguard keeps their expense rations low by using many indexed mutual funds instead of paying managers to do the investments.

    Good point about the ETF market price going up and down as opposed to the mutual fund price being the same all day. The mutual fund has to wait until all of the underlying stocks are priced for the day before they can determine the Net Asset Value (NAV) of the mutual fund share – this usually takes several hours after market close to accomplish!