An exchange-traded fund (ETF) is a pooled investment vehicle that is traded on a stock exchange—a hybrid between a mutual fund and an individual security, wherein the assets are similar to a mutual fund but can be bought or sold throughout the day on a stock exchange at a market-determined price like a stock. They were developed in 1993 as a new way to invest in the securities of an index and since have become a popular investment option in which trillions have been invested, according to the Investment Company Institute. The financial firm sponsoring the ETF compiles a portfolio of stock or bond securities and places it into a specially structured account; in exchange, the firm receives a block of shares (similar to a fund’s shares) of equal value. The firm then sells those shares in the form of a single security to investors on the open market.
ETF shareholders are entitled to a proportionate amount of any income, capital gains, or losses realized by the underlying portfolio, the value of which is reflected in the ETF's share price. The share prices are linked to the value of the underlying portfolios. An ETF’s actual share price, however, is determined by market supply and demand, just like the price of an individual stock or bond. Therefore, an ETF's share price may vary somewhat from the market value of the securities in the portfolio.
Today, most ETFs are passively managed index funds and have principally become popular as a way to gain exposure to a wide variety of market indexes. Like index mutual funds, passively managed ETFs can offer broad diversification, low fees, and tax efficiency. But unlike index funds, ETF shares can be traded on the major exchanges like individual securities. Generally, net asset values (NAVs) for index mutual funds are updated once per day, and investors can only buy or sell mutual fund shares at the NAV price regardless of market activity. If the market declines drastically over the course of a trading day, investors can only exit the fund at the NAV price, which is set at the close of trading.
A typical S&P 500 ETF, for example, is backed by a portfolio that invests in the stocks contained in the S&P 500 Index, and is designed to replicate the performance of that index. However, ETFs are not limited to the U.S. blue chip stock market. Investment companies have developed ETFs that represent various bond markets, non-U.S. indexes, and market sectors.
Actively managed ETFs make up a smaller percentage of the overall ETF marketplace. Similar to an actively managed mutual fund, the actively managed ETF’s investment adviser uses a mix of investments to meet a particular investment objective and policy. Actively managed ETFs must disclose daily the identities and weightings of the component securities and other assets held by the ETF on their publically available websites. However, most active managers prefer not to reveal daily portfolio changes in order to avoid market front-running (a practice in which investors load up on shares of companies that large mutual funds purchase, thereby making the trades more costly for the fund firms), which can diminish potential returns for fund investors.*
Today’s ETFs are similar to index funds in that they constitute a single investment providing access to a diversified index portfolio. ETFs are different in that they trade on an exchange like a stock or bond. For that reason, ETFs have a number of unique properties:
- ETFs are traded freely on the open market, and their prices respond quickly to market activity.
- You can place stop and limit orders on ETFs (if permitted by your broker), sell ETFs short (subject to exchange rules), or buy ETFs on margin (with borrowed money).
- Trades in ETFs incur commissions and possibly other brokerage fees.
- Generally, ETFs have low management fees.
- ETFs typically provide high tax efficiency because they have low portfolio turnover.
Their qualities make ETFs attractive to many investors, but there can be disadvantages for some investors. See The Potential Risks and Rewards of ETFs to learn more.
*Leveraged ETFs can be complex and may carry substantial risk. Many leveraged and inverse leveraged ETFs are designed for short-term trading since they reset daily and seek to achieve their return objectives on a daily basis. Performance may differ from the performance of the underlying index and may not meet the performance expectations that may be suggested by their names. For more information, you should consult the website of the issuer of the ETF you are considering.
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