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Exchange-traded fund

An exchange-traded fund (ETF) is an investing vehicle that holds a group of stocks and can be traded on major stock market exchanges like a stock.

Expanded Definition

If you've ever invested in a mutual fund or index fund, then you know that there is only one time per day when you can buy or sell those shares -- the end of the day after the market closes. That's because the mutual fund calculates is net asset value (NAV), which is the "share" price, by noting the closing price of all the securities it holds after the markets close.

However, if you want to trade shares of an index during the day, then the ETF is for you. These are like index funds in that they own shares of the companies that make up the index, but whose own shares can be purchased or redeemed in real time during normal market hours.

When these were first introduced in the early 1990s, the SPDR ("spider") (ticker SPY) which tracks the S&P 500 index was the first in 1993, they tracked major indexes. But as their popularity has grown, the indexes that these follow have narrowed and specialized so that nowadays you can purchase an ETF and be exposed in an instant to just about any sector or sub-sector of the economy. Want only gold mining? There's an ETF for that. Want only Brazilian companies? There's one for that, too.

While such diversity makes it easier for investors to become diversified into specific sectors, the specialization can increase risk just as much as buying individual stocks by concentrating a portion of your portfolio into one particular industry or portion of it. So use these with care, Fool.

Investors trying to decide between between an ETF and a similar mutual fund should consider the costs in his particular situation. When held in a brokerage account, some brokers charge transaction fees for mutual fund transactions. Those fees are often much higher than discount broker commissions. Hence, they can make mutual fund ownership costly. But when held in an account at a mutual fund company, the fund company often provides account services at no additional charge. The services are paid for by the fund expense ratio. Most brokers have a list of funds with no transaction fees, though that list can be limited compared to the number of funds available. Some brokers now advertise free commissions for ETF transactions. Some mutual fund companies charge annual account maintenance fees for accounts below specified minimums. Investors should consider all costs for the investments they plan and choose accordingly.

One should also note that most ETFs are not managed. You are buying a security composed of a collection of stocks purchased at a fixed ratio. If market conditions change for some of those stocks, your only option is to sell the ETF. Fund management rarely changes the composition of the ETF.

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