It was State Street Global Advisors that launched the first exchange-traded fund (ETF) in 1993 with the introduction of the SPDR. Since then, ETFs have continued to grow in popularity and gather assets at a rapid pace. The easiest way to understand ETFs is to think of them as mutual funds that trade like stocks. Of course, trading like a stock is just one of the many features that make ETFs so popular, particularly with professional investors and individual investors who are active traders. Let's go over these attractive features. (For a background on what ETFs are and how they work, check out Introduction to Exchange-Traded Funds.)

The Benefits of Trading Like a Stock

The easiest way to highlight the advantage of the ETF trading like a stock is to compare it to the trading of a mutual fund. Mutual funds are priced once per day, at the close of business. Everyone purchasing the fund that day gets the same price, regardless of the time of day their purchase was made.

Because, like traditional stocks and bonds, ETFs can be traded intraday, they provide an opportunity for speculative investors to bet on the direction of shorter-term market movements through the trading of a single security. For example, if the S&P 500 is experiencing a steep rise in price through the day, investors can try to take advantage of this rise by purchasing an ETF that mirrors the index (such as a SPDR), hold it for a few hours while the price continues to rise and then sell it at a profit before the close of business. Investors in a mutual fund that mirrors the S&P 500 do not have this capability - by nature of the way it is traded, a mutual fund does not allow speculative investors to take advantage of the daily fluctuations of its basket of securities. (Learn more in Mutual Fund Or ETF: Which Is Right For You?)

The ETF's stock-like quality allows the active investor to do more than simply trade intraday. Unlike mutual funds, ETFs can also be used for speculative trading strategies, such as short selling and trading on margin. In short, the ETF allows investors to trade the entire market as though it were one single stock.

Low Expense Ratios

Everybody loves to save money, particularly investors who take their savings and put them to work in their portfolios. In helping investors save money, ETFs really shine. They offer all of the benefits associated with index funds - such as low turnover and broad diversification (not to mention the often-cited statistic that 80% of the more expensive actively managed mutual funds fail to beat their benchmarks) - plus ETFs cost a lot less.

Compare the Vanguard 500 Index Fund, often cited as one of the lowest of the low-cost index funds, and the SPDR 500 ETF. The Vanguard fund's expense ratio of 21 basis points is significantly lower than the 100+ basis points often charged by actively managed mutual funds. But when compared to the SPDR's 9.5-basis-point expense ratio, the Vanguard fund's expense ratio looks quite high. In fact the SPDR is 45% lower, which is tough to argue with.

Do keep in mind, however, that because ETFs trade through a brokerage firm, each trade incurs a commission charge. To avoid letting commission costs negate the value of the low expense ratio, shop for a low-cost brokerage (trades under $10 are not uncommon) and invest in increments of $1,000 or more. ETFs also make sense for a buy-and-hold investor who is in a position to execute a large, one-time investment and then sit on it. (Find out more advantages of ETFs in 10 Ways ETFs Can Grow Your Portfolio.)

ETFs come in handy when investors want to create a diversified portfolio. There are hundreds of ETFs available, and they cover every major index (those issued by Dow Jones, S&P, Nasdaq) and sector of the equities market (large caps, small caps, growth, value). There are international ETFs, regional ETFs (Europe, Pacific Rim, emerging markets) and country-specific (Japan, Australia, U.K.) ETFs. Specialized ETFs cover specific industries (technology, biotech, energy) and market niches (REITs, gold).

ETFs also cover other asset classes, such as fixed income. While ETFs offer fewer choices in the fixed-income arena, there are still plenty of options, including ETFs composed of long-term bonds, mid-term bonds and short-term bonds. While fixed-income ETFs are often selected for the income produced by their dividends, some equity ETFs also pay dividends. These payments can be deposited into a brokerage account or reinvested. If you invest in a dividend-paying ETF, be sure to check the fees prior to reinvesting the dividends, as some firms offer free dividend reinvestment, while others do not.

Studies have shown that asset allocation is a primary factor responsible for investment returns, and ETFs are a convenient way for investors to build a portfolio that meets specific asset allocation needs. For example, an investor seeking an allocation of 80% stocks and 20% bonds can easily create that portfolio with ETFs. That investor can even further diversify by dividing the stock portion into large-cap growth and small-cap value stocks, and the bond portion into mid-term and short-term bonds. Or, it would be just as easy to create an 80/20 bond-to-stock portfolio that includes ETFs tracking long-term bonds and those tracking REITs. The large number of available ETFs enables investors to quickly and easily build a diversified portfolio that meets any asset allocation model.

Tax Efficiency
ETFs are a favorite among tax-aware investors because the portfolios that ETFs represent are even more tax efficient than index funds. In addition to offering low turnover - a benefit associated with indexing - the unique structure of ETFs enables investors trading large volumes (generally institutional investors) to receive in-kind redemptions. This means that an investor trading large volumes of ETFs can redeem them for the shares of stocks that the ETFs track. This arrangement minimizes tax implications for the investor exchanging the ETFs since the investor can defer most taxes until the investment is sold. Furthermore, you can choose ETFs that don't have large capital gains distributions or pay dividends (because of the particular kinds of stocks they track).

The reasons for the popularity of ETFs are easy to understand. The associated costs are low, and the portfolios are flexible and tax efficient. The push for expanding the universe of exchange-traded funds comes, for the most part, from professional investors and active traders. Nevertheless, long-term investors will find that the broad-market based ETFs can find a place in their portfolios when they have an opportunity for occasional large-size purchases of securities. Investors interested in passive fund management, and who are making relatively small investments on a regular basis, are best advised to stick with the conventional index mutual fund. The brokerage commissions associated with ETF transactions will make it too expensive for those people in the accumulation phase of the investment process. (Be sure to educate yourself on both sides of the story, read 5 ETF Flaws You Shouldn't Overlook and ETF Tracking Errors: Is Your Fund Falling Short?)

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