ETF Basics

ETFs - or "exchange-traded funds" - are securities which are listed on an exchange and traded intraday at a price set by the market, similar to stocks. Not all ETFs are the same, but before examining the different types of ETFs, let's quickly review the features common to most of these investment products:

Historically, most ETFs attempted to replicate the performance of a stock or bond index, and are therefore referred to as index or index-based ETFs. These ETFs attempt to "track" their chosen indexes by holding a basket of securities representing those indexes. Recently, actively managed ETFs have been introduced which permit the fund manger to buy and sell securities and derivatives according to the strategy stated in the fund's prospectus. Such ETFs are required to disclose their holdings daily on their fund's website. As with mutual funds, both kinds of ETFs help diversify your investments. The diversification created by holding multiple securities can help reduce your investment risk, although it cannot ensure a profit or guarantee against a loss.

Some of the most popular index ETFs track the very largest and well-known stock and bond market indices — the S&P 500, NASDAQ Composite Index and Barclays Capital U.S. Aggregate Bond Index. Some ETFs track indices that are based on the market capitalization of the underlying companies (e.g. small cap ETFs). Other index-based ETFs track more narrow segments of the market, such as the financial or commodities sectors. Some index ETFs even track international markets, including specific countries and regions around the world. Leveraged and Inverse ETFs seek to provide a return a multiple of an index's performance (or inverse of performance) over a specific, pre-set time period, typically daily

What are some features of ETFs

ETFs are traded on an exchange. That means that ETFs, like stocks and unlike mutual funds, can:

• Trade like a stock while the markets are open
• Utilize different types of orders, such as "limit orders" and "stops" to help mitigate risk
• Trade at a price set by the market
• Trade with bid/ask spread, which may be narrow or wide depending on the demand for the individual ETF

ETFs may be subject to trading 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 can make investing more expensive than a no-load or transaction-fee fund. Some financial service companies may offer free commissions for certain ETFs traded online.

ETFs are subject to ongoing management and operating expenses. These expenses cover the cost of managing and operating ETFs and are expressed as an annualized percentage of the ETF's net assets. In the ETF's prospectus, they may be referred to as "expense ratio", "management fee" or "investor fee". The fees are included in the NAV.

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. There are no sales loads or redemption fees associated with ETFs. Other fees like trading commissions for buying and selling and management and operating expenses 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. Many 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 shares. 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 other reasons. Please consult the prospectus of any ETF you are considering to learn more about its tax considerations.

ETFs tend to have lower investment management fees because they are mostly index funds. While some costly 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 of any ETF you are considering to learn more about associated fees and expenses.

What are some of the Risks of ETFs?

ETFS are subject to market volatility and the risks of their underlying securities, which may include the risks associated with investing in smaller companies, foreign securities and fixed income investments. Investors should read the fund's prospectus to make sure they understand the fund's risks.

Tracking Error

The return of an ETF is usually different from that of the index it tracks, and it may be small or large. This difference is often referred to as "Tracking Error", however, there is a difference of opinion among investment professionals as to whether the costs of running an ETF should be considered tracking error or not, because indexes, unlike ETFs, are hypothetical, unmanaged portfolios with no management or operating costs. In any case, the costs of running an ETF will usually cause the ETF's return to be different from that of its benchmark index. Some other common factors that may cause tracking error are the timing of the ETF's trades and the ETF holding a smaller basket of securities than the complete set of securities held by the index or holding securities in a different proportion than the index. Regulations governing a fund's diversification requirements and concentration limits may not permit an ETF to hold the same securities in the same proportion as the index. For indexes comprised of thousand of securities, it may not be cost efficient to hold that many securities.

Spread risk

An ETF may sometimes trade at a premium or discount to its Net Asset Value (NAV), which is calculated based on the closing prices of its underlying securities, subtracting expenses and dividing by the number of shares outstanding. The premium or discount to NAV can lead to differences between the bid and ask of the ETF, referred to as the "spread". The ETF's premium or discount to NAV and its bid/ask spread may be the result of such things as supply and demand in the market, the lack of liquidity of some of the ETF's underlying securities, or the bid-ask spreads of the ETF's underlying securities.

Narrowly focused ETFs

There are risks associated with ETFs that target a small universe of stocks, such as a specific region or market sector. Investors should be aware of the inherent concentration risk of a small basket of stocks as a result.

Leveraged and Inverse ETFs

Unlike traditional ETFs, Leveraged and Inverse ETFs are not designed for buy-and-hold investors who seek 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 in the Leveraged and Inverse section) the returns of leveraged and inverse ETFs can differ significantly, both positively and negatively, from that of their benchmark index, especially over investment periods lasting longer than their rebalancing period.