Exchange-traded fund (ETFs)

As its name implies, an ETF or exchange-traded fund is a fund that trades on an exchange, as opposed to being redeemed or sold back to the issuer.
An ETF is typically an index fund, so if an investor wants to do as well as an index, she can track that index by purchasing an exchange-traded fund (ETF). To track the S&P 500, she can buy the "Spider," which is so named because it is an "SPDR" or "Standard & Poor's Depository Receipt."

Of course, we already saw she could do that with an S&P 500 open-end index fund. But, that is an open-end fund that must be redeemed. No matter what time of day, if we put in a redemption order, we all receive the same NAV at the next calculated price. So, if the S&P 500 drops 80 points in the morning and rises 150 points by mid-afternoon, there is no way for us to buy low and then sell high. ETFs facilitate "intra-day trading," which means you can buy and sell these things as many times as you want throughout the day.
Unlike the open-end versions, these ETFs can be bought on margin and can be sold short by investors who are "bearish" on the overall market or an index. If an investor is bearish on technology stocks overall, the answer might be for him to sell the QQQ short, as it represents the NASDAQ 100, the 100 hundred largest non-financial Company stocks trading on NASDAQ If he's right, he'll profit as those stocks drop in price. Or, an investor mostly in large cap stocks could hedge his risk by selling Shares of the Dow ETF (Diamonds) short. This way if the index rises, his stocks make money, and if the index drops his short sale makes money.

So, are the ETFs cheaper than the open-end index fund versions?
Depends how you do it. For a small amount of money, the open-end mutual fund is a great option. For larger amounts of money, though, the ETF is typically cheaper, as the flat commission paid becomes a smaller and smaller percentage of the amount invested. In other words, if the commission is $10 either way, a purchase of $300 is a bad idea, while a purchase of $30,000 would make that $10 insignificant.

As with the open-end index funds, ETFs offer diversification. For a rather small amount of money, an investor can own a little piece of, say, 500 different stocks with the SPDR, or 100 stocks with the QQQ It is also easy to implement asset allocation strategies with ETFs. An investor can find ETFs that track all kinds of different indexes (small cap, value, growth, blue chip, long-term bonds, etc.).

If an investor wanted to be 80% long-term bonds and 20')/0 small-cap stock, that goal could be achieved with just two low-cost ETFs. This point is not necessarily a comparison to the open-end index funds, which would offer the same advantage. Rather, it is a comparison to purchasing individual bonds or small cap stocks. To spread the risk among many bonds and small cap stocks, an investor would have to spend large sums of money. With an ETF (as with the open-end index funds) diversification can be achieved immediately with a much smaller investment.

An ETF such as the SPDR (SPY) or Mid-Cap SPDR (MDY) is appropriate for most investors with a time horizon and risk tolerance suitable for stock (equity) investing in general.


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