Exchange Traded Funds

By: National Endowment for Financial Education | Source: National Endowment for Financial Education | June 19, 2006

Exchange-traded funds (ETFs) are stocks that act like mutual funds. Most ETFs duplicate a stock or bond market index, such as large and small U.S. company stocks, industry and country sectors, and bond indexes. But they are bought and sold like stocks on major exchanges. They have grown tremendously in popularity in recent years.

Types of ETFs

• Broad-Based ETFs track a variety of indexes including those for growth and value stocks and small, mid-size, and large U.S. companies.
• Fixed-Income ETFs track indexes for corporate and Treasury bonds.
• International ETFs track indexes for over a dozen individual foreign countries as well as world regions (e.g., Latin America) and broad-based global indexes.
• Sector ETFs track specific industries such as technology and health care. (Note: There is less diversification in sector ETFs than those that track broad-based indexes.)
• Actively Managed ETFs allow managers to trade in and out of stocks and bonds.

As with all investments, ETFs have advantages and disadvantages. They're good for some investors and not good for others.

Advantages of ETFs

• Diversification - ETF portfolios consist of many securities, thereby reducing investment risk.
• Investment Selection - With their surge in popularity, ETFs are available that focus on the major market segments.
• Liquidity - ETFs can be bought and sold anytime during a market trading day.
• Low Expenses - ETF expense ratios are low.
• Performance - Over time, indexed investments, such as ETFs, perform better than most actively managed mutual funds.
• Simplicity - ETFs are easy to understand. For indexed ETFs, their portfolios include securities within a benchmark market index. Their performances track the index itself.
• Tax Efficiency - The portfolio turnover of most ETFs is low, resulting in lower taxes.
• Trading Flexibility - Investors can decide when to sell ETF shares and pay capital gains taxes, if any.

Disadvantages of ETFs

• Market Risk - Like stocks, ETF share prices are affected by current events, economic conditions, supply and demand, and other factors.
• Tracking Error - Some ETFS under-perform their index. This is primarily due to operating expenses, portfolio diversification rules, and sampling errors when ETFs include just part of an index's securities.
• Trading Costs - Brokerage commissions are charged every time ETFs are bought and sold. Expenses can be reduced, however, by trading large dollar amounts at one time and using a discount broker.

Overall, ETFs may be attractive to investors with large, infrequent lump sum deposits (e.g., 401(k) plan rollover funds). "Buy and hold" investors may want to consider ETFs as a core holding for retirement. ETFs are also a good option for investors wishing to diversify within a narrow asset class (e.g., a single foreign country or industry sector).

ETFs are not suitable for systematic investors who make regular deposits at regular time intervals (e.g., $100 per month) or short-term investors who trade shares frequently. The reason is the high cost of recurring brokerage commissions.

This column is meant to provide general financial information; it is not meant to substitute for, or to supersede, professional or legal advice.

Note: The content areas in this material are believed to be current as of this printing, but, over time, legislative and regulatory changes, as well as new developments, may date this material.

©2006 National Endowment for Financial Education. All rights reserved.