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HELEN HUNTLEYQ. What are exchange-traded funds?
ETFs are baskets of securities that trade just like individual stocks. The baskets are designed to closely track the performance of an index, such as the Standard & Poor's 500 Index. They are substitutes for traditional index funds. Most ETFs invest in stocks, but some invest in bonds.
Q. How are ETFs different from traditional mutual funds?Investors buying or selling shares of a traditional fund deal with the fund company, either directly or through a broker. The fund company has to put the cash to work by buying stocks when investors buy shares or selling stocks to raise cash when investors redeem their shares. Transactions are at the closing price for the day. With ETFs, investors usually buy and sell from each other in trades executed through a stock exchange. Really big investors can deal directly with the fund company, but when they sell, the fund company can pay them in shares of stock from the fund's holdings instead of cash. This creates less disruption for the fund. Shares of ETFs can be bought or sold any time during the trading day and can be sold short, a bet that their price will fall.
Q. What are their advantages?In addition to trading flexibility, ETFs have very low expenses. They also are more tax-efficient, generating fewer capital gains. They are very easy to use to diversify assets. They also are an attractive option for foreign investors who face restrictions on investing in U.S. mutual funds. A Canadian version, known as iUnits, qualifies for Canadian retirement plan investments.
Q. What are their disadvantages?The biggest is the cost of trading. There is a brokerage commission whenever you buy or sell an ETF, which makes them unsuitable for investors who are accumulating shares by making small investments. There can be a difference between the share price of an ETF and the value of the assets that share represents. Usually the variance is quite small, but it can be bigger if the ETF is thinly traded or if it owns stocks or bonds that are thinly traded, particularly those in developing markets, which are less liquid.
Q. Do I have to go through a broker to invest in ETFs?Yes.
Q. Is there a minimum purchase?No. You can buy as little as one share of stock, but it does not make sense to pay a brokerage commission for such a small purchase.
Q. Can they be used for market timing?Yes. But because shares are priced throughout the trading day, there are no "stale" prices that in-and-out investors can use to take profits out of the pockets of other shareholders.