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What is an ETF?


It's an investment that features elements of mutual funds and stocks. Like a mutual fund, it's a single asset that contains pieces of many others, usually stocks and bonds, and provides similar diversification so that if any one or a few portfolio constituents run into trouble, the over-all effect on the price of the ETF is affected only minimally. Most ETFs, although not all, track the performance of an index like the Standard & Poor's 500 or something more obscure that follows stocks in a particular industry or country or perhaps high-yield bonds.

Another similarity between ETFs and mutual funds is that their operators can create or eliminate the number of outstanding shares in response to demand so that their prices almost always precisely reflect the underlying value of their assets. That's not true of closed-end funds, which are sort of an ancestor to ETFs and occupy a smaller niche in the marketplace. Closed-end funds can trade at steep premiums or discounts to the value of their assets.

The most notable way that ETFs are like stocks is that they are listed on exchanges. That allows investors to trade them throughout the day, while mutual funds are typically priced once every trading session based on the closing levels of the assets they hold. Also like stocks, there is a commission whenever an ETF is bought or sold, but otherwise ETFs tend to have very low operating expenses. Another feature of ETFs that makes them cost-effective for investors is that taxable capital gains (or losses) accrue only when they are sold, as is true for stocks too. A mutual fund, by contrast, is required to distribute gains at least once a year, resulting in potential tax liability, even when investors hold for the long term.

-Conrad de Aenlle