by Paul Lines

Created on: September 16, 2007   Last Updated: February 11, 2011

ETF funds, which first came into being in the early 1990's, have risen sharply in popularity since the beginning of 2006, increasing from 100 to 400 funds in number during that year. However, to understand the process of investing in ETF's, one firstly has to know what they are and how they operate, as well as the risk.

In short, the term ETF stands for Exchange Traded Funds. These funds are similar to mutual funds in their make-up. They comprise a basket of stocks that will replicate the stock market index, although more recently some ETF funds are being developed that link to specific industries and precious metals. It is from this basket of stocks that the ETF shares are bought and sold. However, unlike a mutual fund, which has time trading limitations, ETF shares can be traded at any time of the day.

Invariably the ETF fund will try to replicate the movement of a particular stock market index, usually within the country where it is domiciled, such as the Dow Jones, S&P 500 or FTSE 100 and, historically speaking, this has proved relatively successful in that the funds have performed slightly better than the indices to which they are linked

Like all stock market investment instruments an ETF fund does have its advantages and disadvantages.

Advantages

1. Diversification
ETF's have the same attributes as a mutual fund in that they are spread across a wide range of stocks, thus allowing the diversity of holding, which spreads the risk.

2. Fees:
The fund is index linked rather than professionally managed. As a result, the management charges attracting to these funds is lower. Mutual funds typically charge between 1% and 3% , whereas the maximum charges applied to ETF funds is 1%, with many charging less.

3. Country flexible
Residents of the country are the only one who can purchase US mutual funds. With an ETF this is not the case, For example a UK citizen can purchase US ETF shares, whereas they cannot purchase US mutual fund shares.

4. Tax advantages.
The funds have certain tax advantages. Whereas a mutual fund has to realize capital gain at the time of the event, which can cause a tax liability to the holder, with an ETF the gain is only taxable when the holder sells their ETF shares, much like it would be with an ordinary shareholding.

5. Equity similarity
Another advantage of ETF shares is that they can be treated in much the same way as ordinary stocks. Unlike mutual funds, there is no lower limit in terms of the quantity being bought. Similarly, investors can use the same "sell-short," "stop-loss" and "buy to margin" options that they might with a share transaction, which are other facilities that the holders of mutual funds are denied.

Disadvantages

1. Brokers fees
Mutual fund transactions do not attract brokers fees. However, because the ETF funds are traded on the normal stock markets, these transactions do suffer from broker's fees.

2. Tax disadvantages
Although there are some tax advantages with ETF funds, where it can be adversely affected by tax is in relation to the treatment of dividends for tax purposes. Because of the way the fund is conducted, often the IRS will not treat such earnings as qualifying dividends, which can penalize those who are in tax bands in excess of 15%

It can be seen from the above that investing in an Exchange traded fund is very similar to dealing with ordinary stock, with the exception that the fund is geared to reflect the activity of the index upon which it is based. This is fine as long as that index is improving in value. However, as we all know, shares can go down as well as up. Nevertheless, as long as one abides by the normal investment rules, ETF funds had be an attractive addition to your portfolio.

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