What is an ETF?

Posted by Jill on October 20, 2009

Whether you are investing through tax-advantaged retirement accounts or in other taxable accounts, you might want to consider Exchange Traded Funds, or ETFs, as part of your long-term investment strategy. ETFs are one of several ways to invest in equities. Others include individual stocks, mutual funds, or index funds.

What is an ETF?

An ETF is simply a fund made up of multiple securities, somewhat like a mutual fund. ETFs differ from mutual funds in that they are continuously traded on the stock market (and thus revalued) throughout the day, making it easy to buy or sell at any time.

ETFs can be made up of securities that track a stock index (like the S&P 500) or instead choose to focus on a specific industry and/or country. ETFs are generally not actively managed – unlike a mutual fund the underlying stock investments remain the same from time to time. The price of an ETF is usually very close to the value of the underlying assets, but does not have to be.

ETFs also generate taxable income from dividends and charge a management fee just like a mutual or index fund.

Why choose ETFs?

ETFs are good for you if you have a one-time small investment, as they do not have a minimum investment. Be aware, though, that ETFs charge flat trading commissions that can be costly, so they will eat up a larger percentage of your initial investment the smaller that investment is. Long term, ETFs have lower expense ratios than mutual funds that can make up for the up-front cost. Since ETFs can be sold through a broker throughout the day, they allow investors to use techniques previously reserved for individual stocks such as buying on margin and short-selling.

ETFs are an ideal vehicle for trading a large group of assets at once. However, because of trading commissions, ETFs should be used by those planning to hold the same group of underlying assets for a long period of time. If you rebalance your portfolio often, or plan to purchase small amounts of shares regularly (such as through dollar-cost averaging), index or traditional mutual funds may be a better option for you than ETFs. Bottom line, ETFs are good options for those making a one-time new investment or for those looking to simplify and consolidate several small existing investments.

Getting started with ETF investing

Individual investors can buy and sell ETFs on stock exchanges through any broker, much like individual stocks. If you want to invest some of your retirement funds in ETFs, check with your current 401(k) plan administrator or IRA broker.

If you simply want to begin investing in an ETF outside of a retirement account, check with any major broker such as Fidelity, Vanguard, or Sharebuilder. Make sure to compare several funds to review past performance, dividend payments, and expense ratios. Look for Money Magazine’s recommended ETFs on their Money70 list – there are one or two ETFs in every category.

Further Reading

For more details about ETFs, and how they are created and valued, check out Yahoo!Finance, the Investment Company Institute Factbook, or About.com.

Check back tomorrow for ETFs versus index funds!

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