Exchange Traded Funds (ETFs) began in the United States in 1993. Since then, they have spread to Europe and have exploded in the U.S. They have become popular with individual investors as well as institutional investors. In fact you will find some ETFs contained within some mutual funds.
The nature of the ETF is continually changing. What we can say at this point is that most ETFs are index funds. That is, they follow certain indexes of stocks, like the Dow Jones Industrial Average (DJIA), the S&P 500, the NASDAQ, and other indexes. These are passive funds, the same as mutual fund indexes.
In fact there are many similarities between mutual funds and ETFs. The biggest difference is in how you buy and sell them and how much they cost.
For mutual funds, you will pay fees every year. The fees vary from company to company and with different types of funds. Unmanaged index funds cost the least. The more actively managed a fund, the more expensive. In most cases, there is a minimum deposit for buying a mutual fund.
An ETF, on the other hand, is listed on stock market exchanges and is bought and sold the same as a stock. There is no minimum amount you must buy and buying is as simple as buying a stock. The expense involved in buying and selling an ETF is your brokerage fee. If you buy and sell ETFs frequently, your costs will go up.
Not all ETFs are indexes and not all are passive. Some ETFs are actively traded. These carry the same risks and rewards as an actively traded mutual fund. With a passively traded index, you get diversity and relatively low volatility. With an actively traded fund, you will have higher risk and volatility but will still have diversity and possibly higher returns.
One of the biggest differences in buying ETFs and buying mutual funds is the variety of products available. While mutual funds, by definition, represent a basket of stocks, bonds, or even mutual funds (funds of funds), the ETF can be extremely narrowly defined, even more narrowly defined than a company stock.
For example, you can buy an ETF of precious metals miners, one that follows a mining index. But you can also buy an ETF that follows just the price of gold or the price of silver. The narrower the ETF, the more volatile, generally, and the higher the risk.
So in buying an ETF, like buying any stock, you need to be clear about your openness to or aversion to risk. What is your goal? You can usually get a slow steady return in a sector that is on the rise, with good diversification and low volatility. On the other hand, if you are open to higher risk, you can narrow the sector and go with an ETF with few stocks or even just one product.
The longer you can hang onto your ETF, the lower your costs, since you get hit with charges when you buy and when you sell. Frequent buying and selling is only a good idea if you are an expert trader and can make big profits over the short term. For most of us, it’s wise to get into an ETF that will be good for the long haul and stick with it.