ETF or Exchange Traded Funds
ETF stands for Exchange Traded Fund. Depending on who you are talking to, they are the greatest thing since sliced bread, or a passing fad that you don't need. The truth is probably somewhere in between. We'll guide you through what they are, how to use them, if you even need them, and why they suddenly seem to be everywhere.
You might want to check out the Index Funds Primer.
Not to be confused with Indes Funds, ETF or Exchange Traded Funds are investing's latest "it" child. Exchange Traded Funds are a new take on an old concept. In the more traditional world of mutual funds, a mutual fund is created by a mutual fund company and then that mutual fund compay is responsible for all operations for all of its mutual funds including the buying, selling, and daily pricing of those funds.
Mutual Fund Review
Take the popular American Funds AMCAP fund. This mutual fund was created by American Funds. If you want to buy this mutual fund you go to American Funds (you actually go via a broker or online trading service, but then they send your money onto American Funds.) The price you pay is determined by American Funds according to a great many regulations. Simplified, the price is the underlying value of all the investments held by the mutual fund divided by the number of shareholders. If new investors come along, new shares are created, and the new investors do not affect the share price. If current investors want to sell their shares again, their shares are eliminated and again, their departure does not affect the share price. American Funds calculates the daily price and reports it to the exchanges. American Funds calculates the dividends and capital gains and reports them to you (and the IRS). American Funds collects a fee for these services known as an expense ratio which comes out of your investment in the form of an adjusted share price.
ETF or Exchange Traded Funds on the other hand are traded on the exchanges via their own ticker symbols. You can therefore buy an ETF at 11:22am on a Monday and sell it at 1:47pm on that same Monday. The price you recieve is not determined by the company that created the ETF, but rather by the market itself and the forces of supply and demand. So when an investors sells, another investor buys. This, of course, occurs at a price acceptable to both buyer and seller in the same way that a stock is traded. It is therefore possible that at any given time an ETF can trade for more than its parts are worth (or less). Typically these numbers do not get too far out of line thanks to arbitrage.
ETFs are typical constructed around indexes making them similar, but still very different from index funds which are also constructed around the indexes. Again, the main difference being that an index fund is purchased and sold via a mutual fund company whereas, a ETF is purchased and sold via a brokergage account on the open market.
That then is the major difference that actually matters to you as an investor. With a mutual fund you pay whatever sales charge (or load) there may be, plus an ongoing expense ratio. With an ETF you pay whatever commision charge there may be, plus a management fee to the company that runs the ETF.
Several companies manage ETF products. The largest and best known are iShares and Powershares each of whom runs their products differently.
Some investors choose to invest solely in ETF products. Typically these are your "Indexors," those who believe the markets cannot be beaten and therefore the wise thing to do is to invest solely in the indexes which will therefore provide the same return as any other investment at a lower cost yielding an overall higher return. To invest with this strategy, one would simply purchase whatever number of ETFs they felt necessary to construct their portfolio.
Other investors choose to invest in ETFs as an additional investment to another strategy. The two main types are Core & Sattelite Investors and those who simply want to add additional exposure to another asset class or style. In the Core - Sattelite style, one would purchase an ETF as either the Core or Sattelite. Typical Core ETFs are those based on large indexes along the lines of the S&P 500 or a Total Market Index. Sattelite ETFs tend to be those that invest in very volatile narrow indexes with the hope of high returns. Such indexes would be Microcap indexes or even certain country specific indexes (China is very popular right now) or sometime Gold or Siver indexes. Those adding market exposure may do similar investing to the Sattelite investors. For example, someone with a differsified portfolio of mutual funds may add a small percentage investment in Microcap stocks or China or Gold.
How To Buy ETFs
ETFs are bought and sold like stocks, so you'll need a brokerage account. Online trading accounts by companies like Fidelity or Etrade are most popular for ETF investing.