What Is an Exchange-Traded Fund (ETF)?

Exchange-Traded Fund (ETF)By Rob Wiegland, Staff Writer

An exchange-traded fund (ETF) is an investment fund traded on the stock exchange, just as stocks are traded on the stock exchange. In fact, ETFs can be compared in many ways to a mutual fund that trades like a stock. One of the many investment vehicles available, exchange-traded funds can track all types of indexes, industries and market segments. For example, various ETFs exist to track the technological industry, bonds, the utilities sector and the S&P 500.

The first exchange-traded fund was the Standard & Poor’s Deposit Receipt, or SPDR, which follows the S&P 500 and began trading on the American Stock Market in 1993. The original aim was for the ETF to act as an index fund, mirroring the performance index of a specific financial benchmark. Today, ETFs have expanded to track practically every type of equity, including industries and commodities as well as indexes.

Exchange-traded funds are attractive to some investors because they combine the diversification of a mutual fund with the flexibility of a stock. Unlike most mutual funds, however, an ETF does not have its net-asset value (NAV) calculated at the end of each trading day. Instead, throughout the day an ETF's price changes, fluctuating with supply and demand on the open market.

An exchange-traded fund’s value comes from the worth of its assets, but if the market price of an ETF goes higher than the value of the assets, shares can sell at a “premium”. If the market price falls below the value of the ETF, shares sell at a “discount”. ETF shares are appealing to many investors because they can be traded like stocks on the stock market, allowing for greater investment flexibility.

Exchange-traded funds usually have lower expense ratios than cost index mutual funds. ETFs generally are also more tax-efficient than mutual funds. Shareholders can invest as little or as much as they choose to invest. Additionally, it is often easier to track your ETF asset allocation than is typical for many mutual fund investments.

Because exchange-traded funds are traded like stocks, an ETF can only be sold on the stock market; it cannot be redeemed by a shareholder. Also because it is traded like a stock, ETF’s require a commission fee to the broker, not something usually associated with a mutual fund. However, despite these potential drawbacks, an ETF can be a profitable, low-cost, easily diversified investment with more advantages than disadvantages for the right investor.

Both exchange-traded funds and mutual funds are sold only by prospectus, a legal document obtained from your financial professional that includes important information to help you decide if an investment is right for you. Read the document carefully before making your investment decision. Consider your choices wisely before investing, being sure to understand your goals, all charges, and the potential risks and benefits.