Relatively new investors may have heard about ETFs but are still unsure what they are. Well, ETFs, or Exchange Traded Funds, are a type of investment fund that is traded like a stock on the open markets, but typically track an index such as the Nasdaq-100 or S&P 500. First introduced in 1989, ETFs have grown in popularity over the last decade because of their ease to buy and sell, and low expense ratios. However, like any investment, there are pros and cons that the prospective owner should be aware of.

Over the long-term, the S&P 500 beats 80% of actively managed mutual funds (before tax benefits). Because of this fact, prominent investors such as Warren Buffett and Benjamin Graham recommend index funds for defensive investors and those looking to diversify their portfolio. Not only do they provide instant diversification, they also offer the benefit of being simple to own, as it represents owning an already established group of securities selected by finance companies such as Standard & Poor’s, Dow Jones and Nasdaq.

Because index funds strive only to match the performance of its namesake index, they belong to a group of investments known as “passive funds.” Unlike actively managed funds which aim at outperforming an index, there is very little management and therefore overhead in a passive fund, meaning expense ratios as low as a fraction of a percent.

There are two primary ways to own an index: the conventional way is to buy an index mutual fund such as the Schwab S&P 500 Fund (SWPIX). With the advent of the ETF, there is now another option to owning a fund. Examples of popular ETF index funds include Qubes (QQQ) which is the tracking stock for the Nasdaq-100, and the SPDR SPY, which tracks the S&P 500.

ETFs are often cited as superior to their older cousin the index mutual fund. But both offer benefits for various circumstances. ETFs are remarkably easy to obtain; simply call your broker and place an order. There is no minimum holding period as in many mutual funds, and can be sold at any time. Additionally, ETFs are often more tax efficient than mutual funds, because mutual funds can be forced to distribute capital gains more frequently than ETFs. Another advantage of ETFs is that they act like stocks because they are stocks! As such, ETFs can be shorted, where investors make money when the underlying index falls in price. This is a benefit for shorter-term aggressive investors.

Mutual funds should not be forgotten however. Because ETFs are purchased through a stock broker, each transaction incurs a commission fee. For those investors who invest regularly, these commissions can destroy any potential gains from lower expenses over mutual funds. Additionally, mutual funds base their share price on their Net Asset Value (NAV) which means the share price fairly accurately reflects the value of the underlying securities. ETFs however are priced based on supply and demand, and although the prices typically hold constant to the underlying NAV, premiums and discounts can arise, leaving opportunities for even greater (or lesser) profit taking.

For the time being, many think ETFs are useful for investors who are able to buy infrequently, or who want to take advantage of its stock features such as short selling and buying on margin. For investors who invest relatively small amounts of money regularly, index mutual funds are still regarded as the way to go.

For more information about ETFs, I highly recommend taking a look at the fantastic Morningstar.com articles by Chris Traulsen, listed below. And if you have some more time, take a look at some of the other articles as well.

References

[1] Traulsen, CFA, Christopher J. “Exchange-Traded Funds: What You Should Know”. Morningstar.com. Aug. 24, 2000. http://news.morningstar.com/doc/article/0,1,3503,00.html?dType=etf

[2] Traulsen, CFA, Christopher J. “Exchange-Traded Funds: Are They Right for You?” Morningstar.com. Oct. 25, 2000. http://news.morningstar.com/doc/article/0,1,3558,00.html

[3] Traulsen, CFA, Christopher J. “A Note on ETF Premiums and Discounts”. Feb. 2, 2001. http://news.morningstar.com/doc/article/0,1,4178,00.html?dType=etf

[4] ETF Glossary. Morningstar.com.
http://www.morningstar.com/etfglossary/ETFGlossary.html

[5] “Open-ended Fund”. Wikipedia. http://en.wikipedia.org/wiki/Open-end_fund

[6] “Exchange Traded Fund”. Wikipedia. http://en.wikipedia.org/wiki/Exchange_Traded_Fund

[7] “What are index funds?” About.com. http://mutualfunds.about.com/cs/indexfunds/a/index_funds.htm