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What is an ETF and Why Buy It?

Exchange-traded funds, or ETFs, are similar to both stocks and mutual funds.

Like a stock, an exchange-traded fund, or ETF, is a security listed on an exchange. Its share price moves up and down during the trading day, based on how interested - or not - investors are in owning that ETF. You can buy some ETFs on margin, or use stop or limit orders to control the price you pay or receive. When you sell, another investor buys.

Like a mutual fund, an ETF gains or loses net asset value (NAV) based on changes in the value of its holdings, minus expenses, divided by the number of shares. However, unlike a mutual fund, ETFs are not traded just once a day at NAV. The price of an ETF, like the price of a stock, is set by the market. Like an index mutual fund in particular, an index ETF holds a portfolio of investments that are included in a particular index to which the ETF is linked. So you know exactly what the index ETF owns all the time. That's called transparency.

A few things to note. You can't directly invest in an index, so an index ETF's returns won't be exactly the same as the index. Another thing: not all ETFs are tied to an index. Check out the ETF's prospectus for details.

You buy ETFs for the same reason you buy any investment. Owning them can increase the value of your portfolio and may provide income, now or in the future. There is no guarantee that investments, in general, will increase in value, now or in the future, and it's definitely possible to lose money.

Price first. The price you pay per share for an ETF is always less than the cost of buying all its holdings - think of the 2,000 stocks in an ETF linked to the Russell 2000 Index or even the 30 stocks in an ETF linked to the Dow Jones Industrial Average.

Convenience. Do you want to manage a portfolio of 2,000 stocks and 1,500 bonds when two ETFs will do it for you? Enough said. The big point here is that ETFs offer diversification, both individually and as a group. But we have to remind you that diversification doesn't guarantee your investments will gain value, and it doesn't protect you against market losses.

  • There are ETFs that invest in just about every asset class - stocks, bonds, real estate investment trusts (REITs), commodities, and precious metals.
  • There are US-only ETFs and international ETFs.
  • There are ETFs linked to broad indexes, like the S&P 500 that tracks 500 of the biggest US companies.
  • There are ETFs linked to narrow indexes. They hold a limited number of securities in a single sector of the economy, like medical devices or wind power, so they're less diversified than some others.

When investing in an ETF, the first step is to read the prospectus. It's a detailed overview of the ETF's management, investment objective, portfolio holdings, fees, past performance, and risk profile conveniently located all in one place.