What is an "Exchange Traded Fund" (ETF) ?

An "Exchange Traded Fund" or ETF as they are more commonly referred to, is kind of like a mutual fund that trades on a stock exchange and can be traded like a stock.  But there is more to it than that (naturally).  ETF’s do not have active management – rather, they are funds that hold all the stocks in a given market (or index) in the same proportion that they exist in that market (or index) – so if the index (or market) goes up 10%, your ETF goes up 10%.  If the index falls 5%, your ETF falls 5%.  Think of it like a mutual fund without the mutual fund manager.

QuestionMark.jpgNormally, a mutual fund manager would pick and choose which stocks or bonds to hold in their fund.  They would eliminate the stocks they think will under perform the market and allocate more money to stocks they think will outperform the market.  By doing this, they hope to "beat the index".  Historically however, it has been cited and often quoted that 75% of mutual fund managers do NOT beat the index.  If that is indeed the case, then some investors prefer to just "match the market" and save on the additional cost of hiring a fund manager.  An ETF, since it has no manager, has a very low "Management Expense Ratio".  As an example, an average equity mutual fund might have an MER of 2.50% (meaning they will take 2.50% as a fee every year) while an ETF may have an MER as low as 0.09%.  In this case, the mutual fund manager would have to beat the index by more 2.41% every year just to match the performance of the ETF.

ETF’s offer a low cost method of investing in many different markets and there are currently hundreds of ETFs available today representing many different stock market and bond market indices. However, since they trade like stocks, there will be a commission to buy and sell a position in ETFs – hence they are cost prohibitive for smaller investors – especially those who are contributing on a monthly basis or in small amounts.  For example, if you are saving $100/month to your investments and decide to put that into an ETF, your commissions per month may be between $20-$40 – meaning you would have to gain 20-40% just to break even!

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Preet Banerjee
Preet Banerjee
...is an independent consultant to the financial services industry and a personal finance commentator. You can learn more about Preet at his personal website and you can click here to follow him on Twitter.
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