What are Exchange Traded Funds? (And Are They Right For You?)

Exchange traded funds (also known as ETFs) are funds that keep track of the well-known stock indexes: Dow Jones, the S&P 500, NASDAQ, and so on. They are constructed like mutual funds; but like individual stocks, they are priced “on-the-go” and bought and sold through the trading day. Purchasing ETFs, one acquires portfolio shares which track the return and yield of the indices to which they belong. The main distinguishing feature of ETFs (and what sets them apart from other stocks) is that they reflect the performance of the indices they belong to. No attempt is made to do better than that index. In a sense, ETFs can be said to “reflect the market” on Wall Street.

ETFs were introduced in 1993, as a result of the SEC’s “SuperTrust Order” (they became available in Europe in 1999). The first ETF was the SPDR on the S&P 500 index. ETFs derived from the Dow Jones and NASDAQ indices soon followed. Today, they are an integral part of the American Stock Exchange’s trading day.

What Are Exchange Traded Funds?

Chief among the benefits of ETFs is their combination of range and simplicity. An ETF enables a trader to trade a single stock and reap the dividends of a diversified portfolio. Also, portfolios that are actively managed incur administrative costs that are greatly diminished in the case of ETFs (the style in which they are administered is known as “passive management”). Those who purchase them harness the market’s power and make it work for them.

Another benefit of ETF trading is substantial savings on capital gains taxes. Securities trading tends to generate relatively high distributions of capital gains. Passively managed ETFs, by contrast, require fewer trades in and out of the investment instrument, which translates into a better return for investors.

Assuming you understand the risks and benefits of stock trading, ETFs can provide substantive flexibility and lower overall costs as compared with other investment instruments. These benefits (along with the fact that they are tied to the performance of major indices) have made them a popular investment tool, especially over the past several years.

Like ordinary stocks, ETFs allow the investor to take advantage of options, short-selling and limit orders. They often trade on commodities such as precious metals and oil. Before the SEC approved ETFs in 1992, securities could either be exchange listed or open-ended. This relatively new investment instrument combines aspects of both.

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