How Exchange Traded Funds Work - Part I

Exchange traded funds (ETFs) are relatively new forms of financial instruments. The exchange traded funds have grown in popularity by leaps and bounds in a relatively few years. In many instances exchange traded funds have eclipsed mutual funds as investment destinations. This is due to unique advantages ETFs have over mutual funds. In this article I define ETFs, their advantages, and disadvantages.

What Is an Exchange Traded Funds?

Basically, an exchange-traded fund is like a mutual fund that trades similarly to a stock. The ETF contains a variety of stocks as would an index fund, such as the S&P 500. However, an ETF isn’t a mutual fund but trades like any regular equity on a stock exchange.

Unlike a mutual fund which has a net-asset value (NAV) that is calculated at the end of each trading day, an exchange traded fund’s price fluctuates throughout the day.

ETFs attempt to imitate the return on indexes, but there is no guarantee of it. Exchange traded fund’s usually trade at a 1% or more difference with the actual index’s year-end return.

Herein, exchange traded funds give you the diversity of index funds and the flexibility of a stock. ETFs can be traded like common stocks; you can buy them on margin, can sell them short, and have no minimum limits, you can purchase even one share.

Unlike mutual funds the expense ratios of a majority of ETFs are lower than most average mutual fund. Also, like stocks whenever you trade ETFs, a commission is paid.

Assortment of Exchange Traded Fund

There are hundreds of exchange traded funds with a wide variety of sector-specific, broad-market indexes, and country-specific on the open market.

Every kind of sector of the market is represented by ETFs. Some popular ETFs have names like vipers (VIPERs), cubes (QQQQ), and diamonds (DIAs). Exchange traded funds are managed passively not actively like mutual funds. Actively managed mutual funds come with management fees that are missing in ETFs. These are some popular ETFs:

• Nasdaq-100 Index Tracking Stock (QQQQ)
  • Represents the Nasdaq-100 Index, which contains the100 largest and most actively traded non-financial common stocks on the Nasdaq. QQQQ gives broad exposure to the technology sector. This ETF is an opportune way to invest long-term in the technology industry. Instead of buying a single tech stock, with a QQQQ you can diversify in the entire tech sector.

• iShares
  • Probably the only ETFs class synonymous with exchange traded funds, iShares. Barclay’s Global Investors “BGI” has branded iShares and sells them to investors. There are over 120 forms of iShares.

• SPDRs
  • One of the most popular exchange traded funds, referred to as spiders. SPDRs bundle the benchmark S&P 500 and offer the ownership in the index. Imagine attempting to purchase all 500 stocks in the S&P 500 in a cost-effective manner.
  • Additionally, SPDRs are divided into various sectors of the S&P 500 stocks and sell them as   separate exchange traded funds.

• Vipers
  • Like Barclay’s, Vanguard offers its own version of iShares called VIPERs. Various types of Vanguard Index Participation Receipts ETFs are marketed to consumers including investments in the financial, healthcare and utilities sectors.

• DIAMONDs
  • ETF shares that track the Dow Jones Industrial Average. The fund is a unit investment trust. The symbol is DIA which trades on the AMEX.