What Is an ETF (Exchange-Traded Fund)?

The father of exchange-traded funds, Nathan “Nate” Most certainly left his mark on the industry after he thought up of the radical idea that mutual funds could be traded like stocks. After nearly six years of design work and wrangling with regulators to approve his creation, Nate was able to launch the largest and most successful ETF of all time: the Standard & Poor’s Depository Receipt, better known as the Spider or SPY [see also Brief History Of ETFs].

An exchange-traded fund is an investment vehicle that trades on an exchange. Like a mutual fund, an ETF is a bundle of securities, but instead of being priced based on net assets at the end of each trading day, ETFs are listed on intraday trading exchanges and can be bought and sold throughout the day. Most ETFs are index funds that passively track a benchmark [read more on Why Invest with ETFs? A Beginner’s Guide to ETF Investing

The creation of an exchange-traded product involves what is called an Authorized Participant, or AP. The Authorized participant goes into the secondary market to buy individual shares of securities that have been chosen to be included in the ETF. Then, the Authorized Participant delivers this basket of securities to the ETF issuer in exchange for shares of the ETF. The shares that are delivered to the ETF issuer, however, are not kept as inventory, but instead the issuer “issues” new ETF shares in the primary market– this is where the exchange-traded fund is actually created [see also Why An ETF Can’t Collapse]:

Since SPY’s inception in 1993, the ETF industry has experienced rapid expansion and development; in the last two decades, total assets under management have swelled to a staggering $1.9 trillion and counting. Since 2001, the industry has expanded nearly 2000%:

It is very difficult to beat the market picking individual stocks or investing in an actively-managed mutual fund (especially after incurring the fees associated with both). So with investing, it’s usually best to live by the maxim: “If you can’t beat ‘em, join ‘em.” The fact is that you’re not likely to beat the market. But you can match the market with index ETFs. As building blocks, exchange-traded funds provide the most efficient and low cost ways for investors to construct a well-balanced and diversified portfolio.

And with over 1,600 products to choose from, investors can gain exposure to nearly every corner of the investable universe, utilizing very simple and straightforward strategies (like the “plain vanilla” SPY) to the very granular and complex (such as the hedge fund-like QAI) [see more than 50 all-ETF model portfolios with a free 14-day trial to ETF Database Pro].

They can be traded just like stocks at any brokerage firm. We recommend an online-friendly, discount brokerage firm, like Scottrade or Zecco.

Several online brokerages offer commission free trading in certain ETFs, meaning that investors do not have to pay the typical fee incurred when buying and selling a security if they meet certain requirements (generally a minimum holding period) [see a full list of Commission Free ETFs].

In total, there are more than 60 ETF issuers, offering a wide array of products that can fit nearly every investment objective. In terms of product count and total assets under management, iShares is by far the largest and one of the most popular issuers. The other major ETF issuers include:

• State Street SPDR
• Invesco PowerShares
• ProShares
• Vanguard
• WisdomTree
• Charles Schwab

While the majority of exchange-traded funds invest in common stock, investors still have plenty of options to choose from; including exposure to fixed income instruments, preferred stocks, commodities, real estate, currencies, alternatives, as well as a combination of any of these asset classes. Our ETFdb ETF Screener is a great place to start for those looking to gain exposure to a particular asset class.

There are two reasons why index ETFs are often better than index mutual funds: 1) The management fee and expense ratio of mutual funds usually exceed that of an ETF (check out the ETFs with the lowest expense ratios); 2) ETFs allow for intraday trading, whereas mutual funds do not. Below is a table highlighting the key benefits of ETFs over mutual funds [check out our Mutual Fund To ETF Converter Tool]:

Since most ETFs are designed to track an index, they usually are subject to much lower turnover than an actively-managed mutual fund, which reduces the frequency of tax gain distributions. (More info on ETFs and taxes)

ETFs are designed to trade at a price close to its underlying benchmark index. Arbitrage traders in the secondary market limit the gap in price between the ETF and its benchmark. Although, because of numerous market forces, there are often times where the ETF will trade at a slight discount or premium to its benchmark [see How Well Do The 5 Biggest ETFs Track Their Indexes?].

The lowest expense ratio currently available in the ETF universe is 0.04%. The industry average holds steady around 59 basis points, but some niche funds like Teucrium‘s Sugar Fund (CANE), AdvisorShares STAR Global Buy-Write ETF (VEGA), and Van Eck Market Vectors CEF Municipal Income ETF (XMPT) can charge between 1.70% to even 2.32%. Investors trading through firms like Vanguard, Fidelity, or E*TRADE should check out which ETFs are offered commission free for their investors.

Thanks to the rapid expansion of the industry, ETFs are now some of the most heavily traded financial instruments on Wall Street. Here’s a look at six of most liquid ETFs:

Leveraged ETFs were first introduced in 2006, and since then have become immensely popular among investors looking to accomplish a variety of objectives. While the intricacies surrounding these products have been subject to scrutiny, the underpinnings and mechanics of these products are actually quite simple.

Most leveraged ETFs are designed to deliver a multiple (such as 2x or -3x) of their under underlying on a daily basis (before fees and expenses, of course). There are a number of ways for leveraged ETFs to achieve the amount of exposure necessary to deliver these returns. While the exact blend of securities used may vary from fund to fund, most of these products use various derivatives to accomplish the states objectives [see Under The Hood Of Leveraged ETFs].

Although various exchange-traded product structures are often lumped together as ETFs, they offer exposure to the related asset class in very different ways. ETFs maintain a portfolio that corresponds to an underlying benchmark, while ETNs are debt securities issued by a financial institution that pay a return linked to the performance of an underlying index [read more about ETNs in the Ten Commandments of ETF Investing]; investors can hold the debt security until the point of maturity. An ETN’s purpose is to manufacture a security type that couples the benefits of both bonds and ETFs. Like ETFs, ETNs are traded on major exchanges.

An ETF explanation that’s so simple you can hit fastballs as you say it!