Exchange Traded Funds (EFTs)
What are exchange traded funds? What are EFTs? Exchange traded funds, or ETFs, are securities that resemble mutual funds but trade like stocks. Essentially, an exchange-traded fund is a portfolio of securities that trades like a single security. ETFs have been trading in the U.S. since 1993.
ETF securities often track a major market index, such as the Dow Jones Industrial Average or the S&P 500, or an index that represents a certain sector or industry. For example, investors can buy ETFs that represent basic materials companies, utility companies, or financial service companies. ETFs also exist that represent commodities, such as oil, gold, or other assets. By design, the price movements of the exchange-traded funds fluctuate with the price movements of the underlying asset or index.
The creation unit feature, which allows large institutional investors to swap shares of the exchange traded fund for blocks of the underlying assets, acts as an arbitrage mechanism that serves to keep the value of the exchange traded fund equal to the value of the underlying securities.
Exchange traded funds offer the diversification of a broad basket of securities, such as that of a mutual fund or index fund, and the flexibility and liquidity of a share of stock. ETF investing also has several other benefits when compared to mutual funds or even individual shares of stock, including low expenses and tax benefits.
Unlike mutual funds, which are priced at the end of the day according to net asset value, the price of an exchange-traded fund fluctuates throughout the day as traders buy and sell shares. The fees and expenses associated with an exchange traded fund are less than those associated with a mutual fund, and ETFs are much more liquid than mutual funds. With an ETF, traders can buy and sell shares of the fund throughout the trading day.
Like shares of stock, exchange traded funds can be sold short, traded on margin, and bought in quantities as little as a single share. The dealer or broker commission paid on an exchange-traded fund purchase is similar to that of a common stock purchase. And for tax purposes, an ETF investor incurs capital gains taxes only when he sells his shares. Or they incur capital gains taxes when the ETF changes to better reflect the underlying index or assets.