The Motley Fool

What is: An Exchange-Traded Fund (ETF)?

An exchange-traded fund (ETF) is an investment vehicle that holds a group of stocks and can be traded on major stock market exchanges just like a stock.

If you’ve ever invested in a mutual fund or index fund, then you know that there is only one time per day when you can buy or sell those shares — the end of the day after the market closes. That’s because the mutual fund calculates a net asset value (NAV), which is the „share“ price, by noting the closing price of all the securities it holds after the markets close.

However, if you want to trade shares of an index during the day, then an ETF is for you. These are like index funds in that they own shares of the companies that make up the index, but whose own shares can be purchased or redeemed in real time during normal market hours.

When these were first introduced in the early 1990s, the SPDR („spider“), which tracks the U.S. S&P 500 index, was the first in 1993. At first ETFs only tracked major indexes. But as their popularity has grown, the indexes that these follow have narrowed and specialized.

Today you can purchase an ETF and be exposed in an instant to just about any sector or sub-sector of the economy. Want only gold mining? There’s an ETF for that. Want only Brazilian companies? There’s one for that, too.

While such diversity makes it easier for investors to become diversified into specific sectors, the specialization can increase risk just as much as buying individual stocks by concentrating a portion of your portfolio into one particular industry or portion of it. So use these with care, Fool.

Investors trying to decide between between an ETF and a similar mutual fund should consider the costs and their own particular situation. When held in a brokerage account, some brokers charge transaction fees for mutual fund transactions. Those fees are often much higher than discount broker commissions. Hence, they can make mutual fund ownership costly.

But when held in an account at a mutual fund company, the fund company often provides account services at no additional charge. The services are paid for by the fund expense ratio. Most brokers have a list of funds with no transaction fees, though that list can be limited compared to the total number of funds available.

Investors should consider all costs for the investments they plan and choose accordingly.

It’s also important to remember that most ETFs are not managed. You are buying a security composed of a collection of stocks purchased at a fixed ratio. If market conditions change for some of those stocks, your only option is to sell the ETF. Fund management rarely changes the composition of the ETF.