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Exchange-traded Funds

The innovators who introduced the first retail ETF in 1993 created a unique and increasingly popular investment product by combining characteristics of individual stocks with other features of mutual funds.

When you own shares in an ETF, you participate in the overall performance of an entire portfolio of securities included in the index that the fund tracks. If the index increases in value, your ETF shares may increase in value. If the index falls, the value of your shares may fall. These changing values happen and are reported in the blink of an eye.

ETFs and Stocks

Like stocks, ETFs are listed on an exchange, such as the New York Stock Exchange (NYSE) or the NASDAQ Stock Market. In fact, the most actively traded security in the United States is the original retail ETF: the SPDR S&P 500, better known as the "spider". Also like stocks, ETFs are usually very liquid - you can buy and sell ETF shares throughout the trading day. The market price, or the price that shares are trading, rises and falls according to supply and demand.

But while stocks don't have a fixed value, an ETF does. It's known as net asset value (NAV) and is calculated by dividing the value of the ETF portfolio (minus fund expenses) by the number of outstanding shares. Ideally, the market price of an ETF is very close to its NAV, so you don't have to pay more than a share is worth or sell for less. That's more likely with broad-based, widely traded ETFs than with ETFs that track narrowly focused indexes and may trade less often.

ETFs and Index Funds

Like index mutual funds, most ETFs are linked to a specific index, which means that its performance reflects the combined performance of the portfolio that the index tracks. In fact, the closer the return of the fund or ETF is to the return of the index, the happier investors tend to be. That said, you can't invest directly in an index, and an index doesn't include any fees or charges that a fund may have.

But there are some major differences as well. One of the biggest is that ETFs trade throughout the day at the current market price, but a mutual fund's price is determined by its NAV. It changes price only once a day, at the end of the trading day. All transactions for the day happen at that price. What's more, if you want to sell your ETF shares, they're simply traded on an exchange to another investor. To sell shares of any mutual fund, your broker notifies the fund, and it buys back the shares you want to sell at the current NAV.

To be able to make good on that practice, an index mutual fund must hold some of its assets in cash rather than investing them, which may reduce return somewhat. An ETF sponsor doesn't have to do that. And index mutual fund investors who don't sell their shares may face potential capital gains tax if the fund has to sell shares to meet its obligations to redeem. That doesn't happen with an ETF.

Distinguishing Marks

ETFs have a lot of similarities, but each is a little different in ways that make it a distinctive investment.

  • The majority of ETFs track an established index, but there are a few ETFs that are actively managed and aren't linked to an index. These ETFs will likely have a higher expense ratio.
  • Most ETFs track stock indexes, while others track bond indexes. Whether the ETF tracks stocks or bonds, you still buy shares in the ETF. Bond ETFs and Stock ETFs each have a unique set of risks, so know what you're investing in before you take the plunge.
  • Each ETF has a distinctive identity that includes the brand name of its sponsor and a ticker symbol that identifies it on the exchange where it is traded.
  • Each ETF has its own fee structure, which is reported as an expense ratio. If an ETF's expense ratio is 0.48%, and you've invested $10,000, then your share of managing that ETF costs you $48 a year. The less you pay in fees, the more of the ETF's return you get to keep.
  • Often, brokerage firms charge a commission when you buy or sell an ETF. If a sales charge applies, your costs can add up if you trade regularly or use a buying strategy known as dollar cost averaging, which involves making regular, fixed-amount purchases of the same investment.

Key Terms Mentioned

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