What is an ETF?

What is an ETF or Exchange Traded Fund?

By J Biri

Exchange Funds are investment funds developed in the late 1990′s to early 2000′s as an alternative to mutual funds. Initially the exchange traded funds tracked the major stock indexes such as the Dow Jones Industrials, the NASDAQ, and the S&P 500; however, there are ETFs today whose assets include oil and other commodities; precious metals, such as gold and silver; domestic and international bonds, such as US Treasury bonds. Investors who prefer to monitor sectors of the economy as opposed to individual stocks.

How are Exchange Traded Funds Created?

Exchange funds are created by major investment firms who have undergone a stringent qualification process overseen by the Security and Exchange Commission (SEC). The investment houses, known as “market makers” construct the stockfunds from individual assets that represent the sector the fund tracks. The ETF is then sent for approval by the SEC by the market maker. Once approved, the assets within in the fund are held by a custodial bank. The shares in the ETF are then placed for sale on the open market. Investors can buy and sell exchange traded funds on any of the major stock exchanges.

The Advantages of an Exchange Fund

Exchange traded funds offer several advantages as compared to other forms of investment funds.

Some of these advantages include:

  • Transparency as to what assets are included in the fund;
  • The fees associated with ETFs tend to be lower than mutual funds and are clearly stated;
  • The price of the shares of ETFs tend to correlate closely with the value of the assets in the fund;
  • Since exchange traded funds can be traded at any time during regular trading hours, they offer greater liquidity as opposed to mutual funds;
  • An ETF is less exposed to capital gains so they have tax advantages as compared to mutual funds and individually traded stocks.

The Top Performing Exchange Traded Funds of 2011

Just as the markets perform differently from year to year, so does an exchange fund. However, the ETFs in the following sectors performed the best in 2011:

  • United States Treasury Bonds;
  • Gold, silver and other metals;
  • Oil;
  • Utilities.

As with any other type of investment, an exchange fund does carry a risk that the investor will lose the money they invested in fund; although the risk is somewhat less with exchange traded funds. Prior to investing in exchange funds, it is best to review the prospectus and determine if the fund fits with your level of risk tolerance and overall investment strategy. Additionally, consider discussing the exchange traded funds you are considering with your investment or financial advisor as the world economy changes weekly affect broad sectors and these professional will have the knowledge as to what sectors are the least volatile.

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