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What Is An ETF (Exchange-Traded Fund)?

by Daniela Pylypczak-Wasylyszyn on February 14, 2013 | Updated January 16, 2015

An exchange-traded fund is an investment vehicle that trades on an exchange. Like a mutual fund, an ETF is a bundle of securities, but instead of being priced based on net assets at the end of each trading day, ETFs are listed on intraday trading exchanges and can be bought and sold throughout the day. Most ETFs are index funds that passively track a benchmark [read more on Why Invest with ETFs? A Beginner's Guide to ETF Investing ].

Who Invented ETFs?

The father of exchange-traded funds, Nathan “Nate” Most certainly left his mark on the industry after he thought up of the radical idea that mutual funds could be traded like stocks. After nearly six years of design work and wrangling with regulators to approve his creation, Nate was able to launch the largest and most successful ETF of all time: the Standard & Poor’s Depository Receipt, better known as the Spider or SPY [see also Brief History Of ETFs ].

How Are ETFs Created?

The creation of an exchange-traded product involves what is called an Authorized Participant, or AP. The Authorized participant goes into the secondary market to buy individual shares of securities that have been chosen to be included in the ETF. Then, the Authorized Participant delivers this basket of securities to the ETF issuer in exchange for shares of the ETF. The shares that are delivered to the ETF issuer, however, are not kept as inventory, but instead the issuer “issues” new ETF shares in the primary market– this is where the exchange-traded fund is actually created [see also Why An ETF Can't Collapse ]:

How Large Is The ETF Market?

Since SPY’s inception in 1993, the ETF industry has experienced rapid expansion and development; in the last two decades, total assets under management have swelled to a staggering $1.9 trillion and counting.  Since 2001, the industry has expanded nearly 2000%:

How Do Investors Use ETFs?

It is very difficult to beat the market picking individual stocks or investing in an actively-managed mutual fund (especially after incurring the fees associated with both). So with investing, it’s usually best to live by the maxim: “If you can’t beat ‘em, join ‘em.” The fact is that you’re not likely to beat  the market. But you can match  the market with index ETFs. As building blocks, exchange-traded funds provide the most efficient and low cost ways for investors to construct a well-balanced and diversified portfolio.

And with over 1,600 products to choose from, investors can gain exposure to nearly every corner of the investable universe, utilizing very simple and straightforward strategies (like the “plain vanilla” SPY ) to the very granular and complex (such as the hedge fund-like QAI )  [see more than 50 all-ETF model portfolios  with a free 14-day trial to ETFdb Pro ].

How Do I Buy And Sell ETFs?

They can be traded just like stocks at any brokerage firm. We recommend an online-friendly, discount brokerage firm, like Scottrade  or Zecco .

Several online brokerages offer commission free trading in certain ETFs, meaning that investors do not have to pay the typical fee incurred when buying and selling a security if they meet certain requirements (generally a minimum holding period) [see a full list of Commission Free ETFs ].

Who Are The Largest ETF Issuers?

In total, there are more than 60 ETF issuers. offering a wide array of products that can fit nearly every investment objective. In terms of product count and total assets under management, iShares is by far the largest and one of the most popular issuers. The other major ETF issuers include:

What Do ETFs Invest In?

While the majority of exchange-traded funds invest in common stock, investors still have plenty of options to choose from; including exposure to fixed income instruments, preferred stocks, commodities, real estate, currencies, alternatives, as well as a combination of any of these asset classes. Our ETFdb ETF Screener is a great place to start for those looking to gain exposure to a particular asset class.

How Is An ETF Different From A Mutual Fund? What Are The Advantages?

There are two reasons why index ETFs are often better than index mutual funds: 1) The management fee and expense ratio of mutual funds usually exceed that of an ETF (check out the ETFs with the lowest expense ratios ); 2) ETFs allow for intraday trading, whereas mutual funds do not. Below is a table highlighting the key benefits of ETFs over mutual funds [check out our Mutual Fund To ETF Converter Tool ]:

Do ETFs Provide Tax Benefits?

Since most ETFs are designed to track an index, they usually are subject to much lower turnover than an actively-managed mutual fund, which reduces the frequency of tax gain distributions. (More info on ETFs and taxes )

How Does The Performance Of An ETF Compare With Its Underlying Benchmark?

ETFs are designed to trade at a price close to its underlying benchmark index. Arbitrage traders in the secondary market limit the gap in price between the ETF and its benchmark. Although, because of numerous market forces, there are often times where the ETF will trade at a slight discount or premium to its benchmark [see How Well Do The 5 Biggest ETFs Track Their Indexes? ] .

What Are The Cheapest ETFs?

The lowest expense ratio  currently available in the ETF universe is 0.04%. The industry average holds steady around 59 basis points, but some niche funds like Teucrium ‘s Sugar Fund (CANE ), AdvisorShares  STAR Global Buy-Write ETF (VEGA ), and Van Eck ‘s Market Vectors CEF Municipal Income ETF (XMPT ) can charge between 1.70% to even 2.32%. Investors trading through firms like Vanguard , Fidelity. or E*TRADE  should check out which ETFs are offered commission free  for their investors.

Category: Forex

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