An exchange traded fund, commonly referred to as an ETF, is an investment vehicle that is a hybrid between a traditional stock and a mutual fund. An ETF is traded on the open market and often used in an investment portfolio, IRA, or retirement plan such as a 401(k). ETFs offer investors a low-cost way to diversify (or leverage) their investments.
ETFs exist to fill a need for investors by offering a low-cost alternative for investing in broad markets or indexes. Although they been blamed by pundits as contributing to volatile market swings, an ETF can be leveraged in things like the total stock market, the S&P 500, the Euro, bonds, or an industry like banking with one simple fund. And the good thing is that you don’t need a masters degree to understand how to invest with ETFs.
ETFs generally have lower expense ratios than mutual funds because they are not traded as individual shares to investors. Rather, they are sold in large blocks to financial institutions who then sell individual shares to investors. This means less number of trades which translates into lower transaction costs.
ETFs are like mutual funds in that they are made up of other investments like stocks, bonds, or commodities. Each ETF has a specific purpose and the underlying investments within it are continuously adjusted to fulfill that purpose. For example, the Vanguard S&P 500 ETF exists to track the S&P 500 and the SPDR Gold Shares ETF exists to track the commodity of gold. Many of the largest ETFs in existence are tied to a market index like the S&P 500, the Russell 2000, or even a segment like small cap or large cap companies. Others focus on international markets, specific industries, or even currency values.
ETFs are a very good way to diversify a portfolio while enjoying a low expense ratio. With such a wide variety of options tracking a range of indexes, markets, commodities, or industries, it is easy for investors to find an ETF to fill a wide range of investment needs. When trading ETFs, however, investors must be diligent in understanding the risk associated with leveraged funds, a commonly-forgotten fact among investors.