Exchange-Traded Funds

Exchange-traded funds (ETFs) are a relatively new type of investment vehicle that offer an alternative to mutual funds. It is estimated that there are 634 ETFs in the U.S., with $559 billion in assets, an increase of $126 billion over the previous twelve months. In contrast, consider that according to the Investment Company Institute (the national association of investment companies in the United States) there are more than 8,000 mutual funds with assets under management of some $12 trillion.

Here's how an ETF works: it holds a basket of assets--stocks, bonds or even futures--that have been selected to represent some well-defined slice of the total universe of investments, like the S&P 500, emerging companies in India, or the U.S. health care industry.  The list of assets in an ETF is completely "transparent"--everyone knows what the ETF owns--and it doesn't change.

The ETF allows and encourages institutional investors to receive or contribute (buy or redeem) large baskets of securities of the same type and proportion held by the ETF.  The ability to purchase and redeem these large blocks gives ETFs an arbitrage mechanism intended to minimize the potential deviation between the market price and the net asset value of ETF shares.

The small investor buys shares in an ETF which gives him an interest in all the assets of the ETF at pretty much the market price.

ETFs have a number of advantages over mutual funds.  Expenses are very low since there is no portfolio management team being paid to research stocks and decide which stocks to buy and sell.  Liquidity is very high.  ETFs can be bought and sold all day long at the current market price.  Mutual funds can only be bought or redeemed at the end-of-day NAV at the end of each trading day.  ETFs are very "tax-efficient."  ETFs incur no capital gains because they are not in the business of buying and selling assets, which produces capital gains or losses.  The ETF investor can take a gain or loss for tax purposes to match his own tax strategy.  Dividends received by an ETF are passed along to investors.

So ETFs provide a great tool for investors who believe in diversification and asset allocation.  On the other hand, if you as an investor believe an astute manager can "beat the market" by picking the right stocks, ETFs won't appeal you.