Exchange Traded Funds

Exchange traded funds, or ETFs, are both a type of index fund and mutual fund.  Traditionally, they are basket funds of like businesses, but they are not necessarily limited to this.  Stocks, bonds, real estate, and even gold can comprise an ETF.  Much like a mutual fund, ETFs cover a wide diversity of investment options.  There are also ETFs that track exchanges themselves, much in the vein of a traditional index.  This gives rises to a common scenario where more than one index is tracking the same group of stocks.  Like any publicly traded stock, they are traded through a brokerage firm.  The same types of trades that you could conduct with a stock, can be executed on an ETF, whether it be selling short or buying on margin.  There are some ETFs that can have options taken out on them.  None of these stock-like features can be found in a mutual fund.

ETFs differ from indices in the frequency that they are traded.  While indices are typically bought and held for long periods of time, ETFs are popular amongst day traders since they tend to be more volatile.  They are also more highly specialized than index funds.  ETFs often focus on specific sectors of industry, such as technology.  ETFs are also relatively new.  It wasn’t until 1993 that the first ETF (Standard & Poors Depository Receipts) was introduced in the United States.  Prior to this, a few funds had been traded in the Canadian Exchange Market. 

If an investor purchases enough of a particular ETF, they have the option of redeeming that ETF in exchange for a representative share of the individual stocks that comprise the fund.  Usually, this must involve a minimum of one creation unit (typically 50,000 shares).  Hefty brokerage fees for the purchase of such a large amount of shares can be avoided this way.  It also creates opportunities for arbitrage, which will be discussed later.

Unlike mutual funds, ETFs are not actively managed.  The stocks for the basket are selected by a market maker and then typically left alone.  On a more practical level, ETFs are not as beneficial as mutual funds if you are looking to periodically invest small amounts.  Because they are traded through brokers, a fee is charged for each transaction.  The fees associated with similar contributions to a mutual fund would be, on average, slightly lower.

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