by A. Luminium

Created on: July 01, 2008   Last Updated: November 07, 2008

ETF is short for Exchange Traded Fund, a relatively new type of mutual fund that is rapidly growing in popularity with investors both large and small. ETFs are not that complicated. An ETF is just a type of index fund that can be traded directly like a stock or a typical closed end fund.

The vast majority of ETFs are based on a stock market index. Examples include the Diamonds Trust (DIA), which holds the 30 stocks in the Dow Jones Industrial Average and the Powershares QQQ (QQQQ), which is comprised of the NASDAQ 100.

There are also many international, sector, and strategy ETFs, all based on market indices that are fairly mechanical in nature, that select stocks based on geographic area, market capitalization, industry, and various other financial criteria, such as growth companies or value oriented companies. An ETF will typically hold all of or enough of the shares comprising an index in such a way that the ETF will mirror the performance of the index itself.

ETFs are created in a similar manner to closed end funds; a fund company buys shares, creates a basket with the shares and then sells pieces of the basket on the open market. Unlike closed end funds, however, ETFs have a special arbitrage mechanism that allows owners of large blocks of the basket to convert their shares in the ETF to the underlying stocks that are held in the basket. New shares in the basket can also be created by large investors who are willing to trade shares in these stocks for ETF shares. They can and will do this any time there is a large enough price difference between the ETF shares and the underlying stocks to make a profit. This mechanism helps to prevent some of the large price disparities between the assets themselves and the price of the shares that are common with many closed end funds.

Since most ETFs are based on an index, their management fees are lower than typical mutual funds and are more in line with those of index funds. However, shares are traded like stocks instead of being bought and sold through the fund company itself. This lowers administrative costs for the company and thus allows for smaller minimum investments.

For example, as of June 30, 2008, both the Vanguard Total Stock Market Index Fund (VTSMX) and the Vanguard 500 Fund (VFINX), their flagship index fund based on the S&P 500, had an expense ratio of 0.15%, with a minimum investment of $3000. Meanwhile, the Vanguard Total Stock Market ETF (VTI) had an expense ratio of 0.07% and a share price of $64.24. The popular S&P Spider ETF (SPY) had an expense ratio of 0.08% and a share price of $128.04. The low expense ratios of many ETFs make them attractive for large institutional investors who need to fill out a portfolio, while the share prices make them available for smaller investors who might otherwise not meet the minimum purchase criteria. It is possible to build a completely diversified portfolio of stocks using nothing but ETFs, the only real disadvantage being that a brokerage commission must be paid anytime shares are bought or sold.

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