Exchange traded funds have been attracting a great deal of attention lately.  They’ve been a favorite of those “in the know” since 1993 when they were introduced in the US, but are now gaining significant mainstream popularity.  Many people aren’t familiar with them, though.

What are Exchange Traded Funds

An exchange traded fund, or ETF, is a fund holding a collection of assets that is traded on the exchange.  They tend to trade at a price that’s approximately equal to the value of their holdings.  ETFs can be tied to an index like the S&P 500 or they can consist of holdings targeting a specific market sector.

A Yahoo article does a good job of explaining just how diverse the range of exchange traded funds options really are:

There are ETFs for large US companies, small ones, real estate investment trusts, international stocks, bonds, and even gold. Pick an asset class that is publicly available and there is a good bet that it is represented by an ETF or will be soon.

Do They Sound Like Mutual Funds to You?

Based on the basic definition, it’s hard to see the difference between an ETF and a mutual fund.  There are important distinctions, though. Mutual funds accept orders during the regular trading days, but all of the buying and selling happens when the market closes.  ETFs work differently.   They trade instantly, just like stocks, from the bell’s opening ring until the last trade is made.

Why are ETFs Gaining in Popularity?

ETF assets were at around $40 billion at the end of 1999.  Now, they hold at least $1 trillion in assets.  They’re popularity is increasing for several reasons.

First, the wide variety of ETF types provides investors with an easy way to diversify their holdings.

Second, many are attracted to their tax efficiency.  Exchange traded funds have one big “tax event” and that’s when you cash out.  That’s when you settle your capital gains bill.

Third, people love the low cost involved with ETFs.  Many of the best only charge around 1/2% in expenses.  That’s incredibly low, making them a potentially profitable investment.

Fourth, exchange traded funds offer a level of flexibility that other funds can’t.  You can buy inverse funds and you can even sell your ETF holdings short.

Fifth, ETFs are easy for new investors to handle.  You can get into these funds with nothing more than a little money and a discount brokerage account.  It’s as easy as buying a little stock–nothing trick or exotic.

Sixth, you don’t need to be a high roller to get involved.  The cost to enter the ETF world is negligible.  You can buy a single share and have a stake in the overall performance of a major index’s primary companies on the cheap.

Is there a Downside to Exchange Traded Fund Investment?

Not really.  Let me rephrase that.  There’s no unique downside to ETF.  There are things that many of us would probably prefer to skip, like paying a broker’s commission at purchase, but that’s a situation applicable to other investment vehicles, as well.  There’s always the chance that the value of the ETF will drop, leaving you with a loss.  Clearly, that’s the situation no matter where you put your money.

If you think you’re the world’s best stock picker and that you can isolate individual holdings that are on the verge of value explosions, you might not be too excited about ETFs.  The most popular ones, those tied to major indexes, will climb or decline over time, but the moves up and down will rarely be all that radical.  That’s different than buying a stock at $10 on Monday and selling it for $20 on Friday.

Overall, ETFs are an attractive investment vehicle for those looking for a long-term option.  Historically, they’re not movers and shakers but the are winners over the longer term and have a number of unique advantages.