Exchange-Traded Funds
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Exchange-Traded Funds
A relative newcomer to the investment scene, the exchange-traded funds (ETFs) have captured investors’ attention. Introduced in 1993 by the American Stock Exchange (AMEX), exchange-traded funds have gained much popularity with investors and advisors.
Things To Know
- The modern ETF is a hybrid investment between an open-end mutual fund and a listed common stock.
- Their costs are generally low because they do not issue and redeem shares.
Yet, the basics of ETFs have been around for many years. The modern ETF is a hybrid investment between an open-end mutual fund and a listed common stock; it trades like a stock or closed-end fund. It may be easy to confuse the features of an ETF with those of mutual funds. Some of the key differences are mentioned below.
How they work
ETFs are investment companies usually organized as unit investment trusts (UIT) or open-end investment companies. An institutional sponsor purchases a portfolio of stock that usually mimics a market index such as the Dow or S&P 500, then trades it to the ETF for "creation units" of the fund, which are basically stock in the fund. A broker can then sell shares of the creation units to investors on an exchange (usually the AMEX). The price of the shares is determined by the market—and may be higher or lower than the net asset value of the ETF shares. Unlike open-end mutual funds, investors must buy and sell their shares on the open market any time during the trading day. Open-end mutual funds issue new shares to, and redeem shares from, investors only after the close of the market on any trading day.
Some notes on costs and taxes
While exchange-traded funds are managed funds (some are passively managed while others are actively managed), their costs are generally lower because they do not issue and redeem shares, nor do they regularly trade securities in the portfolio. Most ETFs must distribute earnings at least annually. ETFs are similar to mutual funds or unit investment trusts for income tax purposes.
ETFs are a lower-cost way to "trade the market" because they typically have low expenses and follow a particular market segment. The major costs of trading ETFs are the brokerage commissions paid when buying and again when selling the shares. As with other funds, expenses and risk should be considered. Expense ratios do vary across funds and should be considered before investing. You should also make sure the risk of the fund is aligned with your risk tolerance and time horizon.
Learn more about the risks of index and exchange-traded funds.