Exchange traded funds are quite complicated to explain, and confuse most investors, so I’ll try to explain them in the most simplistic terms possible.
Basically, an exchange traded fund is much like a closed-end fund in many ways. For example, an exchange traded fund is traded on the general market, it can have a discount rate or a premium rate based upon the market value in comparison to it’s holdings, plus it is based on numerous stocks that make up its’ portfolio.
By having a portfolio that it is made up of numerous stocks just investing in a exchange traded fund gives you a diversified portfolio. I would recommend however that you diversify your funds and investments even when you have funds. If you are investing only in funds then I would suggest diversifying your funds or add other relatively safe products to your investment lineup. One of the major differences however, is that it isn’t managed by any particular manager.
The idea of the exchange traded fund is to replicate the actual market. By this I mean it is literally a scaled down replica of the market itself. This means that it consists of the same stocks that a general market would, but at a more quantitative level. Most of these funds are all computer controlled in order to ensure the proper proportions to the actual market they are representing. The idea behind this is that you are able to keep yourself relatively diversified and have performance that somewhat replicates what the market itself is actual doing as a whole.
The biggest advantage to these types of funds is that you are able to purchase an extremely diversified fund that has relatively low costs, especially in comparison to other funds, and a very low risk. Because of the nature of these types of funds they don’t normally offer quite as substantial of a return as many other funds, but allow for solid investing which is preferred by many companies and organizations for their stability. These funds are best suited for those that can afford to hold them for a long time.
The exchange traded fund really isn’t all that much better than any other type of fund, just different. . It is just another option for the overall diversification of your portfolio that provides a different element for investment options. Keep in mind that even with a solid diversification funds still do have their risks. You have to weigh those risks and potential gains against what your overall investment objectives are.