About Exchange-Traded Fund (ETF)

An exchange-traded fund (or ETF) is an investment vehicle traded on stock exchanges, much like stocks or bonds. An ETF holds assets such as stocks or bonds and trades at approximately the same price as the net asset value of its underlying assets over the course of the trading day. Most ETFs track an index, such as the Dow Jones Industrial Average or the S&P 500. ETFs may be attractive as investments because of their low costs, tax efficiency, and stock-like features. In a survey of investment professionals conducted in March 2008, 67% called ETFs the most innovative investment vehicle of the last two decades and 60% reported that ETFs have fundamentally changed the way they construct investment portfolios.

An ETF combines the valuation feature of a mutual fund or unit trust, which can be purchased or redeemed at the end of each trading day for its net asset value, with the tradability feature of a closed-end fund, which trades throughout the trading day at prices that may be substantially more or less than its net asset value. Closed-end funds are not considered to be exchange-traded funds, even though they are funds and are traded on an exchange. ETFs have been available in the US since 1993 and in Europe since 1999. ETFs traditionally have been index funds, but in 2008 the U.S. Securities and Exchange Commission began to authorize the creation of actively-managed ETFs.

Most investors can buy and sell ETF shares only in market transactions, but institutional investors can redeem large blocks of shares of the ETF (known as "creation units") for a "basket" of the underlying assets or, alternatively, exchange the underlying assets for creation units. This creation and redemption of shares enables institutions to engage in arbitrage that causes the value of the ETF to approximate the net asset value of the underlying assets.

Investment uses

ETFs generally provide the easy diversification, low expense ratios, and tax efficiency of index funds, while still maintaining all the features of ordinary stock, such as limit orders, short selling, and options. Because ETFs can be economically acquired, held, and disposed of, some investors invest in ETF shares as a long-term investment for asset allocation purposes, while other investors trade ETF shares frequently to implement market timing investment strategies.

Among the advantages of ETFs are the following:

• Lower costs - ETFs generally have lower costs than other investment products because most ETFs are not actively managed and because ETFs are insulated from the costs of having to buy and sell securities to accommodate shareholder purchases and redemptions. ETFs typically have lower marketing, distribution and accounting expenses.
• Buying and selling flexibility - ETFs can be bought and sold at current market prices at any time during the trading day, unlike mutual funds and unit trusts, which can only be traded at the end of the trading day. As publicly traded securities, their shares can be purchased on margin and sold short, enabling the use of hedging strategies, and traded using stop orders and limit orders, which allow investors to specify the price points at which they are willing to trade.
• Tax efficiency - ETFs generally generate relatively low capital gains, because they typically have low turnover of their portfolio securities. While this is an advantage they share with other index funds, their tax efficiency is further enhanced because they do not have to sell securities to meet investor redemptions.
• Market exposure and diversification - ETFs provide an economical way to rebalance portfolio allocations and to "equitize" cash by investing it quickly. An index ETF inherently provides diversification across an entire index. ETFs offer exposure to a diverse variety of markets, including broad-based indexes, broad-based international and country-specific indexes, industry sector-specific indexes, bond indexes, and commodities.
• Transparency - ETFs, whether index funds or actively managed, have transparent portfolios and are priced at frequent intervals throughout the trading day.

Some of these advantages derive from the status of most ETFs as index funds.