Learn the ABCs of ETFs

Exchange-traded funds, or ETFs, are index funds that trade like stocks on major stock exchanges. They were introduced to U.S. markets in 1994 and now have a market value of $150 billion. Although that's still a relatively small number compared with the $7.5 trillion held in open-end mutual funds, ETFs are experiencing explosive growth and are now commonly found in the portfolios of institutional and retail investors alike.

ETFs differ fundamentally from mutual funds because they trade continuously during market hours and allow investors to lock in a price at any moment. Open-end mutual funds, on the other hand, are priced once a day using the closing prices of the stocks in the fund.

ETFs offer investors exposure to domestic indices such as the S&P and Dow Jones Industrial Average as well as to various international indices. The specific investment style of an index ETF can represent a specific sector or industry such as semiconductors, a broad market index such as the S&P 500 or a specific basket of stocks. In addition, various funds may focus on differing investment styles such as value or growth.

Virtues and Attractions

Aside from the liquidity benefits, a wide range of factors are behind the surge in ETF popularity:

Diversification: Like index mutual funds, ETFs provide diversified exposure to an index, industry, sector or group of stocks. However, unlike mutual funds, ETFs do so in a single investment vehicle that can often be hedged with options.

Tax advantages: Unlike mutual funds, ETFs have no hidden capital gains; taxes are owed only on gains that are actually realized.

Lower costs: According to Morningstar, the average expense fee for ETFs is 0.46%, and it can be as low as 0.09% for highly liquid ETFs such as the iShares S&P500(IVV Quote). The average index mutual fund expense ratio is nearly double that, at 0.88%.

Transparency: The holdings of index ETFs are available on a daily basis. Active mutual funds generally reveal their entire holdings just twice a year.