An exchange traded fund, usually called an ETF, is an innovative financial instrument which combines the features of stocks with those of mutual funds. An ETF can be purchased and sold all day long, at prices set by the market, unlike ordinary mutual funds that are only bought or sold at a price that is set once a day. In that respect an ETF behaves like a stock. But it is generally diversified, like an old-style mutual fund, because the purchaser of an ETF is usually buying shares of a portfolio containing a variety of stocks, bonds, commodities, or currencies.
Most ETFs are based on stock indexes. There are ETFs based on the Dow Jones Industrials, DIA and IYF for example, that are designed to reproduce the return of the stocks in the popular blue chip average. Other ETFs try to reproduce the return of the stocks of the S& P 500, the Russell 5000, various global and world-wide indexes or indexes related to specific countries or regions, such as Latin America or Africa and the Middle East. Then there are ETFs that follow various sectors of the stock market, like biotech stocks or financials. Most ETFs follow an index of some sort, even if it’s one created specifically for the ETF sponsor in order that they may call their ETF an index fund.
Another category of ETF is the segment that is based on bonds. Examples include AGG, the iShares fund that seeks to reproduce the price and yield of the entire U.S. investment grade bond market. TIP, from the same firm, invests in US inflation protected bonds. Vanguard, known for its low costs, has quite a few bond funds to look at as well as ETFs of many types. Many other companies have bond ETFs.
Another type of ETF is found in the commodity segment. DBC is an ETF that tracks prices of an index of such commodities as crude oil, heating oil, gold, aluminum, corn and wheat. (As I write, the prices of these commodities seem to be going down.) There are ETFs that take smaller slices of this segment, such as agriculture only, or silver, or US petroleum. Of course prices can go down as well as up, and it is possible to gain or lose buying these funds. They do show much less volatility than people experience trading the actual commodity market.
Because markets go down as well as up, there are ETFs that go up when certain markets go down. Examples include FXP, from Proshare, which goes up when certain stocks in China go down, and SRS, which goes up when real estate stocks go down. Many of these ETFs are leveraged, so that they may move twice as much as the market does in a given direction. These are extremely volatile and unpredictable instruments in which it is possible to lose a lot of money.
There are also ETFs which make it possible to bet on the direction of currencies. UUP goes up when the US dollar does, and UDN goes up when the dollar goes down. Both these ETFs, which also have some characteristics of money market funds, are from Powershares. There are also a variety of currency funds from Rydex, which make it possible to bet on the rise of specific currencies such as the Euro, the Swiss Franc, the Australian dollar and others.
It is not necessary to take big risks to use ETFs in a portfolio. They often have lower fees and expenses than other mutual funds, and they are easier to get into and out of. Diversification is key, of course, and research is crucial, but a sound, conservative, relatively low cost portfolio can easily be constructed using ETFs.