Exchange Traded Funds (ETFs)

Exchange Traded Funds: A Primer

ETFs typically come with low expenses, but you need to separate good deals from risky choices.

By Jeffrey R. Kosnett, Senior Editor, Kiplinger's Personal Finance

January 2010

This article appears in Mutual Funds 2010. Buy this special issue.

While the mutual fund may be Americans' investment vehicle of choice, a similar type of investment -- the exchange-traded fund -- is coming on strong. New ETFs are appearing at a rate of one a day. You can now choose from among 750 ETFs, and their total assets are approaching $1 trillion.

As with mutual funds, quantity doesn't mean quality. But ETFs have some advantages you should consider. The main advantage of ETFs is cost: ETFs typically hold expenses down, which means more money in your pocket.

The first ETF available to U.S. investors hit the market in 1993 as a quick way to buy and sell Standard & Poor's 500-stock index. Now, ETFs exist for every imaginable investment category -- from something as narrow as a single commodity (such as timber) or a single industry (such as health care) to something as broad as the complete domestic blue-chip stock market.

Most ETFs cover familiar categories, such as growth stocks or Treasury bonds. A few, though, are quirky. Some track nanotech¬nology companies and other ridiculously thin slices of the market. However, the largest group of new ETFs consists of income funds that invest in Treasury, corporate, muni¬cipal and foreign-government bonds. These ETFs can be a great deal for investors looking for broad diversification in income-producing investments at a low cost.

Below we compare the similarities and differences between ETFs and mutual funds. TAKE OUR QUIZ to see how much you know about ETFs.

Minimum purchase. Traditional mutual funds come with investment minimums -- often $2,500 or more -- but you can buy ETFs for much less. For example, a share of SPY, an ETF that tracks the S&P 500, costs about $110. Many others sell for much less. Of course, you have to pay a brokerage commission when you purchase an ETF, so it would be expensive to buy a small number of shares. (For example, a $10 commission on a single $40 ETF share would immediately put you 25% behind.) But ETFs allow you to avoid the often-high minimums of mutual funds.

Holdings. Typically, an ETF holds a basket of securities that track the performance of a specific stock index, bond index or other benchmark. So ETFs are much like traditional index mutual funds. ETFs cover all the stock, bond, real estate and other investments that make up complete portfolios.

Pricing. An ETF's share price changes throughout the trading day, like a stock's. By contrast, a mutual fund's price, or its net asset value, is set only once a day, after the market closes. That means it's possible to benefit from buying or selling an ETF on the dips and peaks of the day, instead of placing an order and then hop...