by Daniel Xiao Wang

Created on: July 12, 2008   Last Updated: June 09, 2010

An Exchange Traded Fund (ETF) is a financial instrument that represent a basket of stocks that reflect an index.

An ETF is a diversified fund. What that means in that by investing in an ETF an investor is diversifying their investment into a number of securities, specified by the Exchange Traded Fund's prospectus. Most have no manager constantly tending to the fund, so by investing into these ETF funds there should be no expectation of market timing or switching into and out of specific investments.

They are extremely similar to indexed mutual funds in purpose but trades in a different manner.

A mutual fund trades at Net Asset Value (NAV), calculated at the end of each business day. An Exchange Traded Fund trades like a company security on an exchange, with their value fluctuating according to supply and demand throughout the day. An ETF, therefore, does not guarantee that it reflects an index precisely, although they aim to accurately reflect the underlying index. It is not uncommon to find that an ETF annual return differs from the index that it tracks.

Exchange Traded Funds typically have fewer fees than indexed mutual funds as well. This is because many are not actively managed and there is very little turnover. This naturally results in fewer brokerage fees.

In today's investment environment an investor can find an ETF in virtually any sector. The first Exchange Traded Fund was the Spider, an ETF that tracked the S&P, it received the nickname Spider because its ticker symbol was SPDR. This ETF debuted in 1993, now there are literally hundreds of funds.

There are Exchange Traded Funds that invest in the S&P (the Spider), the Dow Jones Industrial (nicknamed Diamonds), and the NASDAQ (nicknamed cubes after it's ticker symbol QQQQ). In addition there are funds that invest in specific industries, specific sectors, even specific countries. There are even ETFs designed to invest in certain sectors that would benefit in the event of specific events. For example, there is a fund that comprises securities that would benefit from a lift of the Cuban embargo.

In conclusion, an ETF is a diversified investment that tracks a specific index and trades on an exchange like a company's stock. They offer diversification, flexibility, and are less expensive than similar investments. They are ideal for a hands-off investor who likes to "invest it and forget it."

In the approximately 15 years that Exchange Traded Funds have existed they have revolutionized investing for many investors.

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