ETF Basics

ETFs are special mutual funds that are listed on an exchange and can be traded like stocks intraday at a price set by the market. Not all ETFs are the same. Before contrasting the differences among varying types of ETFs, let's quickly review the features common to most of these investment products:

What are ETFs?

Most ETFs attempt to replicate the performance of a stock index or bond index, and are therefore referred to as index or index-based ETFs. Some of the most popular index ETFs tracks the very largest and most popular stock and bond market indices — the Standard and Poor's 500, Dow Jones Industrial Average and NASDAQ Composite Index. Other index ETFs track indices that are based on the market capitalization of the underlying companies (e.g. Small Cap ETFs). There are also index-based ETFs which track more narrow segments of the markets, such as the financial sector or individual commodities (e.g. gold). There also are Leveraged and Inverse ETFs that are designed to return a multiple of a benchmark index's performance (or inverse of performance) over a specific, pre-set time period, typically daily. Finally, there are index ETFs that track international markets, including specific countries and regions around the world. It is extremely important to understand the type of ETF being considered, as each type carries its own risks and features. You should read the prospectus for an ETF before making any investment decision.

Whether for specific stock market indexes, bond market indexes, specific sectors or commodities, index ETFs attempt to "track" their chosen indexes by holding a basket of securities representing those indexes. As with mutual funds, the ETF provides a diversification benefit of holding several securities, and thus reducing the risk vs holding an individual security.

Features of ETFs - how do they work?

ETFs are traded on an exchange:

ETFs are subject to commissions. Because they are exchange traded, ETFs incur trading commissions and are subject to Bid/Ask Spreads, which add to the overall cost of investing in ETFs. These costs also can make investing more expensive than a no-load or transaction-fee fund.

ETFs may or may not trade at the value of their underlying assets. The purchase or sale price on the exchange may be at a premium or discount to the ETF's Net Asset Value.

ETFs have no minimum investment. There are no minimum investment amounts (you can buy as little as one share), but be aware of any commission you may be paying in relation to your investment amount.

ETFs have no loads or redemption fees. Other than the management fee and related expenses, there are no sales loads associated with ETFs; brokerage commissions for buying and selling still apply.

ETFs offer transparency of underlying securities. ETF issuers are required to disclose their funds' holdings every night of trading.

ETFs tend to be tax efficient. Most ETFs are index funds, with low turnover, and thus tend to have fewer securities transactions within the fund that can create capital gains. ETFs also utilize a process called "Create and Redeem" to facilitate investor purchases and sales of the ETF. Under Create and Redeem, ETFs — unlike traditional, open-end mutual funds — do not have to sell individual securities in order to meet redemptions. Instead, when faced with redemptions from investors, ETFs first deliver securities "in-kind" to a special firm known as an Authorized Participant or "AP". The AP works like a clearinghouse, matching the shares of the underlying securities when redemptions come in with those required to meet the demand of new investors. The AP can then select the highest cost basis shares when meeting redemptions. Note that Leveraged, Inverse, and some other ETF products may not be tax-efficient based on the way those products are managed or for other reasons. Please consult the prospectus for the particular ETF you are considering to learn more about its tax considerations.

ETFs tend to have lower investment management fees. While some higher cost ETFs exist, ETFs usually have low expense ratios compared to most actively managed funds. In this sense, the pricing of ETFs can be very similar to traditional open-end index funds, yet most traditional index mutual funds can be purchased without incurring brokerage commissions. Note that Leveraged, Inverse, and some other ETF products may have investment management fees higher than a traditional ETF. Please consult the prospectus for the particular ETF you are considering to learn more about the fees and expenses associated with that product.

What are some of the Risks of ETFs?

ETFs that attempts to track an index often holds a narrow basket of securities rather than complete replication of the index. In these cases there is a possibility that the ETF may not track the index as accurately as with complete replication.

Some of the narrow based ETFs may have risks associated with focusing on a small a universe of stocks; investors should be aware of the inherent concentration risk of a small basket of stocks as a result.

Unlike traditional ETFs, Leveraged and Inverse ETFs are not designed for buy-and-hold investors to track an index over a long period of time. Rather, they are intended for very aggressive, sophisticated investors who actively manage their investments on a daily basis. Due to the effect of compounding (discussed in more detail below) leveraged and inverse ETFs are unlikely to track the performance of the benchmark index over any longer time periods.

While ETFs are generally low cost investment solutions, investors should be aware that the spread (difference between the bid and ask price of the ETF) and commissions can eat into one's returns.

A premium or discount may develop vs the ETF's true Net Asset Value (NAV). This phenomenon often occurs in other exchange traded funds such as Closed-End Mutual Funds, but happens much more rarely with ETFs.

If the issuer of an ETF stops issuing new shares of an ETF, the outstanding shares can begin to trade like a closed-end mutual fund.