Exchange-traded fund

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.

Index basis

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 is used.

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 website.

A series of ETFs introduced by ProShares in 2006 - 2007 no longer follow the traditional definition. These funds, while correlating to the performance of the S&P 500, NASDAQ 100, DJIA, and S&P 400 Midcap, do not attempt to merely achieve the same return as the underlying index. These forty funds attempt to either achieve the daily performance of the designated benchmark times two, times negative one, or times negative two. They are ETFs with integrated leverage.

Another example of an innovative ETF that has broken the classic mold is the oil futures ETF: USO. This ETF tracks the performance of the West Texas Intermediate (WTI) light, sweet crude. This is not a benchmark, but a traded commodity.

Rydex has taken a different direction and worked with S&P to create new, equal-weight benchmarks for their proprietary benchmarks. These "benchmarks" are rebalanced quarterly.

Advantages and Disadvantages of ETFs

Being similar to stocks, exchange traded funds offer more flexibility than your typical mutual fund.

• 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 equal).

Unfortunately, exchange traded funds do have some negatives:

• 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 charge).

Usage

Today ETFs present a viable alternative investment option to traditional open-ended mutual funds, especially open-ended index funds. There are many available ETFs that attempt to track all kind of indexes (such as large-cap, mid-cap, small-cap, etc), fixed income, style (such as value and growth), industries, countries, precious metals and other commodities and more are being developed.

ETFs also enable people living outside the United States to participate in US based mutual funds. Traditional open-ended US mutual funds are available only to US residents, whereas anyone in the world can purchase shares in an ETF that trades on the open market.

ETFs vs. open-ended funds

Given that ETFs trade on an exchange, each transaction is subject to the broker's fee. Many mutual funds do not charge such fees. In scenarios where an investor transacts frequently, or for small amounts, these fees for trading ETFs can erode gains and thus make investing in a mutual fund more attractive. However, with the advent of low or no-cost transactions from various brokerages, this advantage of mutual funds over ETFs has been diminished in many cases.

ETF fees also tend to be slightly more transparent than fees for mutual funds. There are no deferred sales charges, or other kickbacks to the dealer. Instead there is a regular Management Expense Ratio (MER), and the initial exchange commission, if any, to purchase the ETF.

There are many advantages to ETFs, and these advantages will likely increase over time. Most ETFs have a lower expense ratio than comparable mutual funds. Mutual funds can charge 1% to 3%, or more; index funds are generally lower, while ETFs are almost always in the 0.1% to 1% range. Over the long term, these cost differences can compound into a noticeable difference.

ETFs are more tax-efficient than mutual funds in some jurisdictions. In the U.S., whenever a mutual fund realizes a capital gain that is not balanced by a realized loss, the mutual fund must distribute the capital gains to their shareholders by the end of the quarter. This can happen when stocks are added to and removed from the index, or when a large number of shares are redeemed (such as during a panic). These gains are taxable to all shareholders, even those who reinvest the gains distributions in more shares of the fund. In contrast, ETFs are not redeemed by holders (instead, holders simply sell their ETF on the stock market, as they would a stock), so that investors generally only realize capital gains when they sell their own shares.

However, there are some potential taxation drawbacks to ETFs in the United States. One argument made in favor of index mutual funds having a tax advantage over ETFs is that ETFs often trade their shares more rapidly to maintain a high cost basis of their underlying shares. This can result in ETF dividends failing to be classified as qualified dividends since the underlying shares don’t satisfy the IRS requirements. This can be a substantial drawback since your ordinary tax rate may be significantly higher than the 15% tax charged on qualified dividends.

Perhaps the most important, although subtle, benefit of an ETF is the stock-like features offered. Since ETFs trade on the market, investors can carry out the same types of trades that they can with a stock. For instance, investors can sell short, use a limit order, use a stop-loss order, buy on margin, and invest as much or as little money as they wish (there is no minimum investment requirement). Also, many ETFs have the capability for options (puts and calls) to be written against them. Mutual funds do not offer those features.

For example, an investor in an open-ended fund can only purchase or sell at the end of the day at the mutual fund's closing price. This makes stop-loss orders much less useful for open-ended funds – if your broker even allows them. An ETF is continually priced throughout the day and therefore is not subject to this disadvantage, allowing the user to react to adverse or beneficial market condition on an intraday basis. This stock-like liquidity allows an investor to trade the ETF for cash throughout regular trading hours, and often after-hours on ECNs. ETF liquidity varies according to trading volume and liquidity of the underlying securities, but very liquid ETFs such as SPY, DIA, and QQQQ can be traded pre-market and after-hours with reasonably tight spreads. These characteristics can be important for investors concerned with liquidity risk.

A more subtle advantage is that ETFs, like closed-ended funds, are immune from some market timing problems that have plagued open-ended mutual funds. In these timing attacks, large investors trade in and out of an open ended fund quickly, exploiting minor variances in price in order to profit at the expense of the long-term unit holders. With an ETF (or closed-ended fund) such an operation is not possible--the underlying assets of the fund are not affected by its trading on the market.