Exchange-traded funds (ETFs) are a “hybrid” investment with characteristics of both stocks and index mutual funds. Like stocks, ETFs trade on stock exchanges and experience price changes throughout each market trading day. Like index funds, they consist of a portfolio of securities that is passively managed. This means that, by definition, ETFs consist of the securities that comprise a specific benchmark market index. ETFs were first introduced in 1993 and have seen tremendous growth in assets ever since.
The most popular ETF, so-called “Spiders” (trading symbol: SPY), an acronym for Standard & Poor’s Depository Receipts, tracks the Standard & Poor’s (S&P) 500 index of large company stocks. The second most popular ETF, formerly referred to as “Cubes” (trading symbol: QQQ) and now called Powershares QQQ, tracks the NASDAQ 100 index of small company stocks. There are also ETFs that track indexes for various industry sectors (e.g., energy, financial services, healthcare, real estate, and technology), different company sizes (e.g., large-, mid-, and small- capitalization stocks), and dozens of foreign countries or regions of the world (e.g., Europe and Asia).
Many ETFs have an even a lower turnover than managed mutual funds. Turnover refers to the frequency with which securities in an ETF portfolio are bought and sold. Changes in an ETF portfolio typically occur only when a change is made to the underlying index upon which it is based. This translates into extremely low expense ratios (i.e., expenses as a percentage of assets), as low as 0.09% (less than a tenth of 1%) to 0.11%, compared to about 0.18% for the least costly stock index mutual funds and much less than the average expense ratio of about 1.5% charged by actively managed (non-index) stock funds.
Another advantage of ETFs, compared to mutual funds, is that investors, themselves, can decide if and when to sell ETF shares and, by doing so, arrange the best timing to incur capital gains tax liability. In other words, investors have the same flexibility to buy and sell shares as they do with individual stocks. With mutual funds, on the other hand, taxable dividends and capital gains, as well as transaction costs, are automatically passed along to fund investors and taxed accordingly.
Below are some recommendations about exchange-traded funds provided by investment experts: