The bear market in the US in the first couple of years of the twenty-first century propelled investors towards
Exchange Traded Funds. They combine the stability of mutual funds with the ease of trading of stocks.
An Exchange Traded Fund (
ETF) is an investment vehicle, much like a mutual fund, through which an investor can own an assortment of companies. An ETF contains a basket of funds or securities, often of the same investment category, such as energy and gold. The most distinguishing factor between a mutual fund and an ETF is that the latter can be traded on exchanges throughout the day like stocks.
Since ETFs can be bought and sold just like stocks, their net asset value (NAV) is not calculated once a day by fund managers, but on a continuous basis throughout the day by investors. Thus, unlike mutual funds, ETFs are open to price fluctuations during the entire trading period. Since ETFs are traded on the stock market through brokers, minimal interaction with fund houses is required. Fees associated with ETFs are also lower that the mutual fund fees. Additionally, ETFs afford greater tax efficiency than mutual funds. While these benefits do exist, the one driving the popularity of ETFs is liquidity.
ETFs have been traded in the US since 1993 and in Europe since 1999. They owe their origin to a product called Index Participation Shares that was traded on the American Stock Exchange and the Philadelphia Stock Exchange in 1989 as an S&P 500 proxy. This product had to be terminated on account of a lawsuit, but was soon followed by a similar product, namely Toronto Index Participation Shares, trading on the Toronto Stock Exchange. This product, which tracked the TSE 35 and later the TSE 100 stocks, became highly popular. In the US, Standard & Poor's Depositary Receipts (SPDRs), or "Spiders," were the first ETF to hit the market. Since then, ETFs have flourished and form a significant portion of trading activity on US bourses. As of May 2008, there were 680 ETFs in the US, with $610 billion in assets, according to wikipedia.org.
An ETF is an ideal asset allocation tool that significantly limits the investment risks associated with individual stocks. However, ETFs are not without shortcomings. As ETFs are a basket of funds from the same investment category, investors have high exposure to any downturn in that specific category. Moreover, too much flexibility to move in and out of an ETF could tempt investors to jump often between sectors, resulting in missed opportunities, wrong decisions and reduced potential returns. Additionally, buying and selling of ETFs involve brokerage commissions, which can erode the low-expense advantage of ETFs, particularly when the sum being invested is limited.
More information on
exchange traded funds can be found here: