Just What Is An ETF?

[This article originally appeared in our July issue of ETF Report.]

You've probably heard the good news about ETFs, about their transparency, flexibility and lower costs. You may have even already put them to use.

Mutual Fund 2.0
Like mutual funds, ETFs are pooled investment vehicles whose managers spread investors' money across a range of assets, including stocks, bonds, commodities, currencies and options. Also like mutual funds, ETFs offer diversified exposure to a particular market segment, such as large-caps or high-tech stocks. Under the hood, an index ETF and mutual fund look similar: e.g., an S&P 500 ETF and mutual fund both track the same index and hold the same stocks in the same proportions.

The difference, however, is right on the tin: ETFs are exchange-traded, meaning you can buy and sell shares of an ETF just as you would shares of stock. Just hop over to your brokerage account and trade away.

Trade On Your Schedule
Mutual fund trades process only once per day, after the close of trading hours. To buy shares, you contact the mutual fund company, which then sends you a number of shares equal to your cash. (That means sometimes you end up with fractional shares—something that doesn't happen with ETFs.)

ETF trading, however, resembles that of stocks. To buy ETF shares, you place an order with your broker, who then searches the market for someone who wants to sell. Your cash doesn't go to the fund company directly, it goes to another investor.

Here's why that matters: Since ETFs trade on exchanges, these trades can happen any time the market's open. If the market spikes, you can get in or out of an ETF right when you need to; no more waiting until next day.

Stocklike Benefits
ETFs offer other benefits too. They usually cost less than comparable mutual funds, as ETF managers wrangle less paperwork and forgo 12b-1 marketing fees. They're also more transparent, because exchanges require ETF managers to disclose fund holdings daily; mutual fund managers only need do so quarterly. ETFs even end up being more tax efficient than mutual funds, though the reasons are beyond the scope of this article.

Plus, because ETFs are exchange-traded, you can pull off all sorts of stocklike strategies you never could with mutual funds: placing stop-loss or limit orders, short selling, even buying on margin.

These benefits come with the headaches of trading commissions, spreads, and premiums and discounts. We'll cover these further in "Top Ten ETF Risks."

That said, ETFs are a powerful tool granting access to almost every market segment and sector, from U.S. equities to high-yield bonds to hedge funds, and more. There's even a new crop of actively managed ETFs that package the alpha of active strategies with the tradability of an ETF.

Remember: An ETF looks like a mutual fund, but trades like a stock. That makes all the difference.