What is an ETF? — Part 1: The Basics

February 29th at 6:00am by Tom Lydon

Exchange traded funds continue to increase in number and popularity, growing to one of the most commonly traded securities on the stock exchange as both institutional and the average retail investor gain greater access to broad or specialized market exposure. Yet many individuals are unfamiliar with ETFs’ inner workings. In this ongoing series, we hope to address your questions and help shed light on the investment vehicle. [What is an ETF?--Part 2: Indexing]

First off, we need to define the investment. What is an ETF?

Exchange traded funds are exactly what their names indicate. They are funds that can be traded on an exchange.

As a fund, the ETF security usually tries to passively reflect the performance of an index, a commodity or a customized basket of assets, similar to traditional index mutual funds. However, the number of actively managed ETFs is growing.

Unlike traditional funds, the ETF can be traded on an exchange like other common stocks. Accordingly, the ETF will show price changes throughout a trading day.

For instance, the largest ETF, SPDR S&P 500 (NYSEArca: SPY), passively reflects the performance of the S&P 500. Over the past three years, the S&P 500 has returned 23.47% while the SPY ETF gained 23.37%, a close match. Year-to-date, the ETF is 9.08% higher, whereas the Index is up 8.96%. In contrast, only 10% of hedge funds have outperformed the S&P 500 so far this year, with hedge funds only averaging 3% so far this year, reports Margo D. Beller for CNBC.

Since ETFs are designed to track the price movements of an underlying, benchmark Index, the investment is considered passively managed, which also helps reduce management costs.

One of the greatest selling points of the ETF product is their low cost. The average expense ratios on most ETFs are lower than the average mutual fund.

While trading an ETF, investors will enjoy the diversification qualities that come with traditional index funds, coupled with the trading options found in individual stocks.

[What is an ETF?--Part 2: Indexing]

Max Chen contributed to this article.

The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.

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