The Basics

Introduction to Exchange Traded Funds

An Exchange Traded Fund (ETF) is a type of investment security that tracks an index, but can be traded like a stock. Because ETFs are traded on stock exchanges, they can be bought and sold at any time during the day (unlike most mutual funds). The price of these marketable securities will fluctuate from moment to moment, just like any other stock's price, and an investor will need a broker in order to purchase them. Exchange traded funds have many of the benefits inherent in Mutual Funds and Index Funds, but are more tax efficient.

The History of ETFs

In 1992, the American Stock Exchange (Amex) used the Securities and Exchange Commission's (SEC) "Super Trust Order" to create the first authorized stand-alone index based ETF. That petition was approved by the SEC, and lead to the inception of the S&P Depository Receipts Trust Series 1, also known as SPDRs or "Spiders". In time, this ETF quickly reached commercial success as the easiest way to invest in all the components of the S&P 500 Index, thereby achieving a high level of portfolio diversification.

Other companies quickly joined the Amex in this fast growing segment, creating a vast list of ETFs that cover a multitude of indices around the globe. Other major issuers of ETFs are Barclays (iShares) and Vanguard (VIPERs). Most exchange traded funds can be found on the American Stock Exchange. The NASDAQ-100 ETF QQQ began trading in 1999 on the Amex, and moved to The NASDAQ Stock Market on December 1, 2004.

ETFs Today

ETF Investing is as popular as ever, with over 180 being traded on the Amex today. However, the most popular ETF in terms of assets is still the original S&P-500 Index Fund SPDRs (SPY), followed by the iShares MSCI EAFE Global Index Fund (EFA) and the NASDAQ-100 Index Tracking Stock (QQQQ).

Advantages of ETFs

Exchange Traded Funds has many of the advantages found in both mutual funds and stock. This makes ETF investing an attractive and convenient investment product for some, take a look at these advantages to see if it is the right product for you.

  • Cost Efficient: Unlike actively managed mutual funds, ETFs track an index, which results in much lower maintenance fees. In addition, there are no buying/selling activities required by the fund to accommodate for shareholder purchases or redemptions, thereby lowering overall costs. There are no sales loads or investment minimums required to purchase an ETF.
  • Tax Advantages: Mutual funds are required to distribute capital gains received from transactions, which results in capital gains taxes for all shareholders. There are no such requirements for ETFs. In addition, when a shareholder chooses to sell his ETF, it will simply be sold in the market to another investor, meaning there will not be any transactions required to adjust the fund's portfolio to accommodate for the sale, and therefore no capital gains for the fund.
  • Flexibility: Exchange Traded Funds are bought and sold just like stock, making it an incredibly flexible investment product. Unlike mutual funds, ETFs can be purchased at intraday prices using stop and/or limit orders, bought on margin, and even sold short.
  • Transparency: Exchange Traded Funds track individual indices or commodities and you can easily tell where your asset is being invested.
  • Diversification: One buy-order effectively spreads your investment into hundreds of stocks. ETFs allow investors to benefit from diversification to reduce risk, while just paying one single stock commission.

Investing in ETFs

One of the biggest draws of Exchange Traded Funds is the ease of buying and selling. If you know how to buy and sell a stock, chances are you're ready to give ETF trading a try.

  • Placing an Order: The process of placing an order for ETFs is exactly the same as those for stocks. Simply go to the stock order entry page, enter the symbol of the ETF you wish to purchase, select the price, shares, conditions, then submit. The order will appear in your order status page in exactly the same way as a stock order would. In fact, some investors might have purchased an ETF thinking that it was a stock.
  • Dividends, Splits, and Proxies: When the stocks held by the ETF issuer receive a dividend or split, the proceeds are passed along as a dividend paid by the ETF to the ETF shareholders. The ETF issuer takes care of all the proxies it receives, and the fund will issue it's own proxy to its shareholders to vote on important topics regarding the fund.

Various Types of ETFs

The Exchange Traded Funds segment of the investment world has come a long way since the days of the lone ETF: SPDRs. Today there are hundreds to choose from, each tracking different indices of equity, fixed income, or even commodities, around the world. Diversify your investment portfolio without going out of your way to purchase other types of products.

  • Global ETFs: There are ETFs tracking indices beyond the domestic markets. Choose from a broad global ETF that covers all major markets outside the U.S., or specific regional funds that track fast growing markets in China and Korea. In the past you would need an account in each country, regulation permitting. Now you can invest in those regions through your brokerage account.
  • Fixed Income ETFs: Many people invest in fixed income products as a source of regular income. Fixed income ETFs declare and pay dividends, if any, on a monthly basis.
  • Commodity ETFs: Exchange Traded Funds that track commodity indices take advantage from gains in the commodities market, or can hedge your equity positions.
  • Currency ETFs: In December 2005, the first currency ETF, Euro Currency Trust (FXE) was introduced by Rydex, which trades on the NYSE. Investors can gain exposure to the Euro currency through this fund.