ETF stands for exchange traded fund. It is a variation of the mutual fund. The ETF is comprised of a specific set of stocks, bonds or commodities. A financial institution creates an ETF by purchasing blocks of the component assets and then resells the shares of the fund to individual investors.
ETF vs Mutual Fund
An index mutual fund values the individual investor's shares at the close of a market day at the net asset value (NAV, assets minus liabilities divided by shares outstanding) of the fund. An ETF share may be bought or sold anytime during a market trading day and the price reflects the open market prices of the assets. This trading mechanism minimizes the deviation between the market price of the fund and the net asset value of the components.
For the knowledgeable, active investor who wants to participate in big picture trends, ETFs have many advantages over the traditional mutual fund. ETFs are far more transparent, efficient and economical. They offer the advantages of index mutual funds: diversification, low expenses and tax efficiency combined with the features associated with individual stocks: limit orders, options and the ability to short sell.
How Long-Term Investors Use ETFs
Holding an index fund or a variety of sector specific ETFs allows the buy and hold investor to diversify his portfolio with a relatively small account balance. The asset allocation is easy to track and adjust since the fund's holdings remain constant and publicly disclosed.
The lower expenses, a result of the passiveness of the fund's management, will, over time, compound in the account's balance. All gains, except for dividends and interest, remain unrealized until the shares are sold, allowing the investor to choose transaction dates based on their personal tax and income needs.
Benefits of Trading ETFs
Active investors, those who buy and sell shares more frequently, appreciate the market timing strategies ETFs allow. No restrictions are placed on the number of trades, the number of shares or the holding periods an ETF trader is permitted. They pay the transaction costs and may play daily, weekly or longer term trends at their sole discretion.
A trader may decide to "short sell" ETFs. This is done by selling borrowed shares in the hope profiting by buying them back later at a lower price. In a declining market, this allows traders to make profits instead of suffering loses as owned shares decrease in value.
Options trading is also available through ETFs. These instruments allow a trader to control shares they do not own--an additional way to profit from ETF movement.
ETFs Are Not for Passive Investors
Don't buy an ETF if you want to hire a fund manager to chose your investments. An ETF's assets are fixed at the time it is formed. If one or more of its components has financial difficulty, the fund does not sell it and replace it with a better stock or bond (unless it goes out of business or is delisted).
A mutual fund manager is paid to find, follow and trade in and out of assets within the fund's parameters. In theory, the professional can anticipate and react to the events that affect the fund's assets and provide the member with a better return than the inexperienced individual investor.
Buying and Selling Through a Broker
You must open an account with a brokerage firm before buying or selling a fund. If you invest through a deferred-compensation plan, your plan's custodian will provide brokerage services for you. Request the list of funds available through your broker, the transaction costs and the process for making transactions. Research the fund's holdings, investment style, past performance and fees and choose one that matches your needs.
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