An Exchange-Traded
Fund (ETF) is a security that tracks an index, a commodity or a basket of securities
unified by a particular investing theme (such as companies whose main business
is biotech). An ETF is similar to a mutual fund, but trades like a stock on an
exchange, thus experiencing price changes throughout the day as it is bought or
sold. However, ETFs differ from traditional mutual funds in how their shares are
issued, traded and redeemed.
ETF shares
are usually created by an institutional investor depositing a specified block
of securities with the Exchange-Traded Fund, and in return for this deposit, the
institutional investor receives a fixed amount of ETF shares, some or all of which
may be then sold on a stock exchange. The primary investment objective of an ETF
is to achieve the same return as a particular market index. Like any other publicly
traded company, ETFs also have ticker symbols. There are a number of different
ETFs on the market at the moment, including SPDRs, sector SPDRs, HOLDRs, iShares
and Diamonds. They are all passively managed, tracking a wide variety of sector-specific,
country specific and broad-market indexes.
Advantages
ETFs
have a better trading flexibility over traditional mutual funds, because you can
buy and sell them at anytime during the course of the day. They can be sold short
and bought on margin. They are often promoted as offering the benefits of index
investing with greater trading flexibility in comparison with mutual funds.
ETFs
are also significantly less expensive than the vast majority of mutual funds,
in terms of the annual expenses charged to investors.
ETFs
are more tax-efficient than most mutual funds, and they may, therefore, hold a
special attraction for investors in taxable accounts because most trading in ETFs
takes place between shareholders, shielding the fund from any need to sell stocks
that would result in capital-gain distributions for the remaining shareholders.
In addition, investors with more than 50,000 shares can redeem their shares for
the underlying stock rather than cash. This means that the gain or loss is deferred
until the investor sells the distributed shares.
Disadvantage
ETFs
may be less expensive in terms of annual expenses. One thing to note is that you
must pay commissions to buy or sell ETFs, just as you would for stock transactions.
For those who trade frequently or invest regular sums of money, it may not be
very cost effective.
Are ETFs Right
For You?
Clearly, ETFs might not
be suitable for everyone even though ETFs have several advantages over mutual
funds. You should consider every advantage and disadvantage to help you determine
what role, if any, they should play in your portfolio.
