ETFs trade on the stock exchange as if they were stock. Generally in the past they have tracked a particular index such as the Dow Jones Industrial Average or the NASDAQ-100. Recently, however, they are forming ETFs that have a particular characteristic in common: they invest in a particular region or sector of the market, or have a certain market capitalization.



Exchange traded funds have many advantages over mutual funds. They are inexpensive to get because, like when purchasing stocks, you are paying a commission. If you use a discount brokerage, you can buy for very little money. The regular maintenance fees for an ETF are also small when compared to managed mutual funds, and sometimes lower than index mutual funds.

Exchange traded funds are liquid because they trade like stock. With a simple phone call you can buy or sell. ETF exchange traded funds are priced every 15 seconds and trade continually throughout the day. This is different from mutual funds that are only bought and sold at the end of the trading day. Since the ETF will be held in a brokerage account, it is easily traded.

Tracking an index means less selling within the fund. This makes for a tax efficient fund. ETFs rarely declare a capital gain. This means you determine when the taxes will be paid on the gain by choosing when you will sell.

Index and actively managed funds retain a portion of their investable assets in cash. This is used to pay someone that is promoting their fund. Because ETFs trade like stocks, there is no need to keep a portion in cash.

There is no room for style drift in an ETF. In an actively managed mutual fund, the fund can say it is a large cap fund, but may chase performance by investing in small or mid caps at times. ETFs are required to maintain a 99% correlation with the index or basket of stocks that it represents.

Regarding ETF trading strategies, because ETFs trade like individual stocks you have the additional features of stock. ETFs can be sold short or on margin. They can have limit, buy and stop loss orders for buying and selling. Call and put options can be bought and sold using exchange traded funds.

There are of course disadvantages to ETFs as well. They are not an appropriate investment to use with dollar cost averaging. If you have to pay a $10.00 fee each month when you make that $50 or $100 investment it can be difficult to make up that fee.

With the popularity of ETFs, you have to be careful as to what the fund is using as its foundation of stocks. Sometimes it can be such a narrow focus that you really are not achieving diversification.

Due to the ease of trading you can get caught up in riskier strategies than you want. Short term trading and market timing can result in significant losses. Buying and selling ETF puts and calls, or buying on margin, is speculating and is riskier than buying and holding.

Exchange traded funds are the right choice under certain circumstances. For your main holding, you can use a broad index ETF. This can be supplemented with targeted ETFs to provide weighting in a particular sector, region or type of market capitalization. As always, be smart and invest slowly.