An exchange-traded fund (ETF) is a security that tracks an index, commodity, or basket of assets. It acts similar to an index mutual fund. Unlike a mutual fund, an ETF trades similar to a stock by reflecting the price changes throughout the trading day.
Exchange-Traded Funds offer investors a way to buy a wide variety of diversified investments in an affordable manner. ETFs offer investment choices from commodities like silver and gold to strategies that short (bet against) bond funds. There is almost no limit to the type of investment or strategy available to investors.
The expense ratio of most ETFs is much lower than an average mutual fund. ETFs do not have front-end charges or back-end charges and expense ratios are often a fraction of what might be charged from an actively managed mutual fund.
ETFs also give investors the ability to sell short, buy on margin, and purchase as little as one share.
Exchange-Traded Funds offer investors a way to buy a wide variety of investments. Yes, this was also an advantage. This also leads investors to pick the “flavor of the month” and invest in vehicles or types of investments that are not understood.
When buying and selling ETFs, you have to pay the same commission similar to buying a stock. However, the industry is starting to trend away from paying a “trading” fee for purchasing or selling an exchange-traded fund.
What to Look For
It is also important to choose an ETF that has a low tracking error. A low tracking error means that the ETF is closely tracking the return of the index or basket of goods it is following. A high tracking error may indicate that an investor is not getting what they are paying for which could sidetrack a portfolio strategy.
Bid-Ask Spread Can Be Large
As more niche ETFs are created you might actually find an investment in a low volume index. This could result in a high bid/ask spread. This can cost a buyer or seller in an inactive market. It is important to choose a large ETF that is actively traded.
Exchange-traded funds have opened up a world of affordable investment options not available just ten years ago. They are a great option for investors looking to lower investment fees and use alternative investments to diversify a portfolio. However, it is important to find an actively traded ETF with a low tracking error and understand the type of investment being purchased