ETF Basics

This information is for educational purposes only
and should not be considered to be investing or tax advice.

Below is a basic overview designed to provide a general understanding of exchange-traded funds (ETFs). After reading this overview, if any portion is unclear to you, or if there is a topic we did not cover, please let us know so we can continually improve it. To contact us, please click here.

What is an ETF?
How is an ETF different from a mutual fund?
Buying and Selling ETFs Expense Ratios
Tax Advantages of ETFs
Shorting and Options
What is the history of ETFs?
What companies issue ETFs?
What different types of ETFs are available?
What is an index ETF?
What is a sector ETF?
What is an industry ETF?
What is a country-specific ETF?
What is a size-specific ETF?
What is a commodity ETF?
What is a currency ETF?
What is a leveraged ETF?
What is a short or bear market ETF?
What is an actively-managed ETF?
Can ETFs be used in a retirement account?

What is an ETF?

An exchange-traded fund, or ETF, is a basket of securities (a fund) that trades like a stock on major stock exchanges. The securities that make up an ETF can be varied and may include such things as stocks, bonds, commodities, or currencies. An ETF may track the performance of a broad index, like the S&P 500, or it may track a specific country, sector, or industry.

How is an ETF different from a mutual fund?

While an ETF as an investment vehicle may be similar to a mutual fund in certain aspects, there are many important differences.

Buying and Selling

Like an ETF, a mutual fund tracks a collection of securities; however, a fundamental difference can be found in how each is bought and sold. An ETF trades during market hours like an individual security and can be bought and sold continuously like any stock. On the other hand, a conventional mutual fund is priced once at the end of each trading day.

Expense Ratios

Typically ETFs are known to often have lower expense ratios than most traditional mutual funds. In 2007 the average expense ratios, per Morningstar’s database, were as follows:

For specific information, please consult the funds’ prospectus.

Tax Advantages

ETFs are structured for tax efficiency and can be more efficient than mutual funds. For example, in the U.S., whenever a mutual fund realizes a capital gain that is not balanced by a realized loss, the mutual fund must distribute capital gains to its shareholders. In contrast, ETF investors only realize capital gains when they sell their own shares or if the ETF changes holdings in its underlying index.

Please note that this site does not offer tax advice and therefore, please refer any tax questions to a tax professional.

Shorting and Options

Similar to common stock, many ETFs can be sold “short” or may be “optionable,” unlike mutual funds, which can only be bought “long.”

What is the history of ETFs?

State Street Global Advisors (SSgA) pioneered the very first exchange-traded fund in 1993. This original ETF, (SPY), tracks the performance of the S&P 500 index, and is one of the most popular ETFs available today-having more assets invested than any other ETF.

What companies issue ETFs?

Currently, there are more than twenty companies offering ETFs. These include companies such as: Barclays Global Investors, State Street Global Advisors, Vanguard, ProFunds Group, Bank of New York Mellon, Merrill Lynch, Rydex Investments, Van Eck Global, WisdomTree, Claymore, Ameristock Funds, First Trust, MacroShares, XShares Advisors, Goldman Sachs Group, Fidelity Investments, Bear Stearns, Northern Trust, GreenHaven Commodity Services, FocusShares, SPA ETF, RevenueShares Investor Services, and Ziegler Capital Management.

For a complete list, click here

What different types of ETFs are available?

There are many different types of ETFs such as: index, sector, industry, country-specific, size-specific, commodity, currency, leveraged, short, and actively managed. Let’s look at these various ETFs in more detail.

What is an index ETF?

An index ETF is considered the most common type of ETF, and tracks indices associated with certain stocks or bonds. An example of an index ETF would be (QQQQ), which tracks the NASDAQ 100 index. Index ETFs are not actively managed, but represent a predetermined index of stocks or bonds. Because there are many different types of indices, there is a rich and widely divergent variety of index ETFs available.

What is a sector ETF?

A sector ETFs holding represents a segment of an economic market. Common sectors include Basic Materials, Consumer Goods, Financial, Government, Health Care, Industrial Goods, Services, Technology, and Utilities.

What is an industry ETF?

An industry ETF represents a particular industry, such as Transportation, and provides investors the ability to track the collective performance of that industry.

What is a country-specific ETF?

A country-specific ETF tracks the performance of the economies of an individual country. Some ETFs track a specific region such as Europe.

What is a size-specific ETF?

A size-specific ETF is defined by the market capitalization of the individual holdings within the fund. For example, the ETF may characterize its holdings as large-cap, mid-cap, small-cap, or even micro-cap to indicate the relative size of the companies that are held within the ETF. Large-cap companies are typically defined as larger than $10 billion in market cap, while mid-cap companies are usually in a range of $2 billion to $10 billion. Small-cap companies range between $300 million and $2 billion, and micro-cap companies are generally $50 million to $300 million.

What is a commodity ETF?

A commodity ETF, tracks the performance of a commodity such a precious metal, oil, natural gas, or wheat.

What is a currency ETF?

A currency ETF provides investors the ability to track the performance of various currencies throughout the world, such as the U.S. dollar, Japanese yen, British pound, or Mexican peso.

What is a leveraged ETF?

A leveraged ETF is designed to magnify the performance of an underlying index. This type of ETF provides investors with the prospect of amplifying their returns when the market responds in an expected direction. As a caution, if the market takes an unexpected turn, the investor will also magnify losses instead of gains.

What is a short or bear market ETF?

A short or bear market ETF is designed to return the inverse or opposite of an underlying index. The short ETF provides investors with an opportunity to benefit from declines in the underlying index. This is becoming a popular way for many investors to hedge their portfolio for downside risk in the markets.

What is an actively-managed ETF?

An actively-managed ETF, new to the market in spring 2008, uses a portfolio manager or mathematical model to actively select the securities to be included in the fund.

Can ETFs be used in a retirement account?

ETFs are becoming more available within retirement plans. Check with your plan administrator.

Things that you should know about ETFs

Advantages of Exchange Traded Funds

• ETFs can be bought and sold throughout the trading day, allowing for intraday trading.
• Investors can short or buy ETFs on margin.
• ETF investors can employ hedging techniques and speculate using options.
• ETFs typically offer lower annual expenses than comparable mutual funds.
• Mutual funds must pay distributions at the end of the year and may be subject to capital gains while ETFs are subject to capital gains when they are sold which allows for more timing regarding the distribution.
• Trading cost when spread across large lump sum investments may be negligible when viewed as a percentage of the investment.  ETFs may be favored for these types of investments.

Disadvantages of ETFs

• Investors may be charged fees when they buy or sell ETFs.
• ETFs may not trade at their net asset value.  An ETF may trade above or below the value of its underlying portfolios.
• Similar to stocks, there is a bid-ask spread, meaning you may buy the ETF for one price while it is concurrently selling at a lower price.  This is basically a hidden charge.
• ETFs can be cost prohibitive due to account charges when employing dollar cost averaging investment strategies (automatically investing small amounts on a scheduled basis).

This information is for educational purposes only

and should not be considered to be investing or tax advice.