Exchange Traded Funds, or ETFs, are similar to mutual funds, but are traded on a stock exchange just like a stock. Exchange traded index investments have become very popular in the past few years, and are now available to track many broad indexes. The S&P 500, the Nasdaq 100, and the Dow Jones Industrial Average are all offered, as well as many narrowly defined sectors and specialty indexes.
ETFs represent shares of ownership in a fund, unit investment trust, or depository receipts. These instruments own portfolios of stocks that closely track the performance of specific indexes that correspond with either broad market indexes or sectors. ETFs give investors the opportunity to buy or sell an entire portfolio of stocks in a single security in a single transaction.
ETFs offer a wide range of investment opportunities. While they closely resemble index mutual funds, ETFs differ from mutual funds in a number of ways. Unlike Index mutual funds, ETFs are priced and can be bought and sold throughout the trading day. They can also be bought on margin and sold short. There is an ever-increasing number of ETFs that can be categorized into three types of funds:
Broad-Based - This category tracks a broad group of stocks from different industries and market sectors. For example, iShares S&P 500 index fund (symbol IVV) is a broad based ETF that tracks the S&P 500.
Sector - These ETFs track companies represented in related industries. For example, iShare Dow Jones U.S. Healthcare sector Index Fund (symbol IYH) is a sector ETF that tracks the Dow Jones Healthcare sector.
International - Tracks a group of stocks from a specific country. For example, iShares MSCI- Australia (symbol EWA) tracks the Morgan Stanley Capital International index for Australian stocks.
ETFs are bought and sold through your broker of your choice - the same way you buy a stock. Most ETFs have no minimum purchase requirements, and you can buy as little as one share at a time. However, some ETFs, like the Merrill Lynch HOLDRS, must be bought or sold in round-lot amounts of 100. All ETFs may be purchased on margin, and are usually subject to the same terms that apply to all common stocks.
It's clear that ETFs offer several advantages to traders and investors. Unlike open-end mutual funds that can only be redeemed at the end of the day, ETFs are priced throughout the day and can be bought or sold at any time during the trading session - just like a stock. They provide instant exposure to a portfolio of stocks of your choice. You can choose a fund that either represents a broad-based market index, a specific industry sector or an international sector.
ETFs can be bought on margin, and sold short. Although brokerage commissions do apply, there are no sales loads, management or sponsor fees typically associated with mutual funds. There are also positive tax implications. Both ETFs and open-end mutual funds provide low stock turnover, which is tax efficient because capital gains are not realized. However, ETFs provide a tax advantage not available with mutual funds.
Mutual funds sell securities to cover redemptions, creating capital gains, while ETFs transfer securities out to redeeming shareholders instead of selling the securities, thus minimizing taxable capital gains. There is also lower risk due to the diversification aspect of ETFs. Proper investment diversification is intended to reduce the risk inherent in particular securities. It is the acquisition of a group of assets in which returns on the assets are not directly related over time. By containing the stocks in an index, an investor has a broader number of companies, which provides a degree of protection in case the price of one company in the index goes lower.
In summary, ETFs provide a convenient way to trade or invest in the overall market or specific sectors. Their performance matches the return of the overall market or individual sectors as a whole. They are usually less volatile than the individual stocks that make up the sector, and provide a relatively low-risk way to trade volatile markets. If you are interested in trading specific sectors, indices, or mutual fund type equities, you should definitely consider Exchange Traded Funds as a part of your stock trading and investing strategy.
For a listing of ETFs go to http://quotes.nasdaq.com/asp/ETFsCompare.asp?query=Intraday