What is an Exchange Traded Fund?

Exchange traded funds are closed-end mutual funds that trade on the stock exchanges like a stock. The first investors in an exchange traded fund participate in the Initial Public Offering (IPO) of the fund. Once the fund is actively traded, new investors buy shares in the fund on the open market. Unlike an open-end mutual fund where the share price is always equal to the Net Asset Value (NAV), the price of an exchange traded mutual fund may be higher or lower than its NAV at any given time. Also, where an open-end mutual fund is priced once per day at the close of the market, an exchange traded fund trades continuously during market hours and the price of the fund fluctuates accordingly.

History

The early exchange traded funds were all equity index funds. They provided investors an opportunity to participate in the overall market without having to buy all the stocks that make up a given index, such as the Dow or the S&P. Even today, the largest exchange traded fund (though it is technically a depository receipt) is the Spider (AMEX:SPY), which indexes to the S&P 500.
Today there are hundreds of exchange traded funds covering every sector of the market. The most recent innovation is the "actively managed" exchange traded fund. This is a hybrid of open end and closed end funds where the fund trades on the exchange just like a stock, but the holdings of the fund are actively managed and any changes to the portfolio are published on the fund's website daily.

Size

One of the things that distinguishes an exchange traded fund from an open end mutual fund is the inherent limit to its size. As an open end mutual fund attracts more investors, more shares are created to accommodate those investors, so the size of an open end mutual fund is theoretically unlimited. With an exchange traded fund, there are a finite number of shares available for purchase and that is why its stock price fluctuates as the market seeks a balance between buyers and sellers.

Considerations

When deciding between an exchange traded fund and an open end mutual fund, an investor should consider the different expense ratios. An open end mutual fund is actively managed and there is constant buying and selling of the portfolio stocks within the fund, so the management fees are going to be much higher than in an exchange traded fund where the portfolio never changes (except with the new actively managed ETFs).

Warning

Exchange traded funds do not have the ability to eliminate losing positions from their underlying portfolios. While it is unusual for an exchange traded fund to trade far below its Net Asset Value, if the fund is heavily invested in a sector that has fallen out of favor the price decline can be very sudden and steep. Also, short selling is allowed in exchange traded funds while it is not in open end mutual funds. Therefore, a heavy short interest in an exchange traded fund can also depress the fund's share price.

Potential

Exchange traded funds are quickly becoming a favored investment of many individuals and institutions. Their popularity has exploded in the last decade and doesn't appear to be abating. As international markets open up around the world, look for the exchange traded funds to provide an easy entry into the new markets and to provide a measure of diversification for the new investors.

Resources

• NASDAQ Exchange Traded Fund Info