Exchange-traded funds (or ETFs) are open-ended investment companies that can be traded at any time throughout the course of the day.
Typically, ETFs try to duplicate a portfolio such as SPY or the Hang Seng Index, a market sector such as energy or technology, or a
commodity such as gold or petroleum; however, as the number of ETFs proliferated in 2006 from under one hundred in number to almost four
hundred by the end of the year, the trend has been away from these simpler index-tracking funds to Intellidexes and other proprietary
groupings of stocks.
The legal structure and makeup varies around the world, however the major common features include:
An exchange listing and ability to trade continually;
They are index-linked rather than actively managed;
Through dynamic and quantitative strategies, these can be dynamic rather than static indexing strategies
The ability to handle contributions and redemptions on an in-kind basis (typically in large blocks of shares only); and
Their 'value' (but not necessarily the price at which they trade—they can trade at a 'premium' or 'discount' to the 'underlying' assets' value) derives from the value of the 'underlying' assets comprising the fund.
These qualities provide ETFs with some significant advantages compared
with traditional open-ended collective investments. The ETF structure
allows for a diversified, low cost, low turnover index investment.
This appeals to both institutional and retail investors both for long
term holding and for selling short and hedging strategies.
Many current U.S. ETFs are based on some index; for example, SPDRs (Standard & Poor's
Depository Receipts, or "Spiders") (AMEX: SPY) are based on the S&P
500 index. The index is generally determined by an independent
company; for example, Spiders are run by State Street, while the S&P
500 is calculated by Standard & Poor's. Sometimes, a proprietary index
Although the SEC states that an ETF is "a type of investment company
whose investment objective is to achieve the same return as a
particular market index," this is no longer reality. The development
of investment structures has progressed more quickly than the SEC's
Advantages and Disadvantages of ETFs
Being similar to stocks, exchange traded funds offer more flexibility than your typical mutual fund.
Unfortunately, exchange traded funds do have some negatives:
ETFs can be bought and
sold throughout the trading day, allowing for intraday trading -
which is rare with mutual funds.
Traders have the
ability to short or buy ETFs on margin.
Low annual expenses
rival the cheapest mutual funds.
Tax efficiency - due
to SEC regulations, ETF tend to beat out mutual funds when it comes
to tax efficiency (if it is a non-taxable account then they are
Commissions - like
stocks, trading exchange traded funds will cost you.
Only institutions and the extremely wealthy can deal directly with the ETF companies (must buy through a broker).
Unlike mutual funds,
ETFs don't necessarily trade at the net asset values of their
underlying holdings, meaning an ETF could potentially trade above or
below the value of the underlying portfolios.
Slippage - as with
stocks, there is a bid-ask spread, meaning you might buy the ETF for
15 1/8 but can only sell it for 15 (which is basically a hidden