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Exchange-traded funds (or ETFs) are changing the way people invest, allowing investors big and small to build institutional-caliber portfolios with lower costs, better transparency and greater tax efficiency than ever before.
But what exactly is an ETF? And why are they such great tools for investors?
A Mutual Fund ... With A Twist
The most important thing to know about ETFs is that they are really just mutual funds … with a twist.
Mutual funds are pooled investment structures. Multiple investors pool their money in a single pot and hire a manager or managers to invest that money. Each investor receives “shares” in the fund in direct proportion to the size of their investment. The fund itself can buy dozens or hundreds or thousands of securities.
An ETF is structured the exact same way. In fact, ETFs are mutual funds and, for the most part, are structured, managed and regulated just like other mutual funds.
With one critical difference: an ETF is exchange-traded, meaning it can be bought and sold on an exchange, just like common stock.
That means you can buy or sell ETF shares from any traditional brokerage account, and trade them just as you would shares of IBM or Cisco. What's more, while buy and sell orders for mutual funds can be processed only once per day (after the close of trading), ETF trades take place immediately. You can purchase or sell shares at any time throughout the trading day—you can even buy shares in the morning, and sell them in the afternoon.
That's just the start. You can perform all sorts of stocklike strategies with ETFs that you never could with mutual funds: selling short, placing stop-loss or limit orders, even buying on margin.
They are exchange-traded funds, and those two words make all the difference.
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