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I've been hearing a lot about exchange-traded funds, or ETFs. What exactly are they, and how would I use them?

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Wikipedia has a fairly detailed explanation of ETFs.

http://en.wikipedia.org/wiki/Exchange-traded_fund

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ETFs offer the flexibility of stocks while retaining many of the benefits of mutual funds. Since an ETF is an actual fund, it has the diversification of its potentially many underlying securities. You can find ETFs with stocks at various market caps and style categories. You can have bond or mixed ETFs. You can even get ETFs with equal or fundamental weighting. In short, all the variety benefits of mutual funds.

ETFs are typically much less expensive than mutual funds both in terms of management fees (expense ratio) and taxable gains. Most of them are not actively managed; instead they follow an index and therefore have a low turnover. A mutual fund may actively trade and, if not balanced with a loss, will generate capital gains that you pay taxes on. An ETF will produce gains only when shifting to keep inline with the index or you yourself sell. As a reminder: while expense ratio always matters, capital gains and dividends don't matter if the ETF or mutual fund is in a tax-advantaged account.

ETFs have no load fees. Instead, because you trade it like a stock, you will pay a commission. Commissions are straight, up-front and perfectly clear. Much easier to understand than the various ways funds might charge you. There are no account minimums to entry with ETFs, but you will need to buy complete shares. Only a few places allow partial shares. It is generally harder to dollar-cost average into an ETF with regular automated investments.

Also, like trading stocks, you can do those fancy things like selling short, buying on margin, options, etc. And you can pay attention to the price fluctuations throughout the day if you really want to.

Things to make you pause: if you buy (no-load) mutual funds through the parent company, you'll get them at no commission. Many brokerages have No Transaction Fee (NTF) agreements with companies so that you can buy many funds for free. Still look out for that expense ratio though (which is probably paying for that NTF advantage). As sort of a middle ground: index funds can have very low expense ratios, track the same index as an ETF, can be tax-efficient or tax-managed, free to purchase, easy to dollar-cost average and easier to automate/understand.

Further reading:

  • Note that the difference in fees between an ETF and a mutual fund is just how things tend to work out, not anything intrinsic about the ETF structure itself. – fennec Mar 29 '11 at 20:25
  • Note also that the important distinction is that mutual funds tend to generate returns that you need to pay capital gains taxes on immediately, sometimes as short-term capital gains - as opposed to when you want to exit the investment years later (and are probably realizing long-term capital gains at a lower rate, and also getting back the cash to pay the taxes with at the same time). – fennec Mar 29 '11 at 20:28

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