A:

Mutual fund use and development has increased rapidly ever since they were first introduced in the early 1920s. In the United States, mutual funds control over $9 trillion in assets. Under the category of mutual funds, exchange-traded funds (ETFs) have been around since the 1990s, and have become one of the most popular classes of mutual fund.

ETFs differ from all other mutual fund classes in that they are traded just like stocks. They are bought and sold on secondary markets such as the NYSE, AMEX, Nasdaq and the TSX. Because of this, ETFs share many of the same characteristics as stocks.

Unlike open-end mutual funds, in which prices are determined at the end of the trading day, ETF prices are changing constantly based on the trading done during the day. Being traded on an exchange also allows an investor to use stop-limit orders to protect his or her investments.

Another commonality between ETFs and stocks is that investors are also able to short sell ETFs. However, short selling ETFs and stocks differ in one significant way: when an investor wants to short sell a stock, he is restricted by a rule called the uptick rule. This is not true of ETFs. This rule only permits short selling to occur when the last price movement of the stock is positive. The rule prevents short sellers from increasing the decline of a stock that is already moving downward. Investors are able to short ETFs even if the price of the ETF is plummeting. The main reason why this is allowed is that ETFs have sufficient liquidity and enough buyers that the likelihood of someone taking a long position is greater.

Since ETFs are not restricted by the uptick rule, they are often used by hedge funds. Hedge fund managers are looking to make fast trades to take advantage of short-term price movements. If they only use stocks, they are limited in their ability to profit on downward price movements. Subsequently, an ETF's exclusion from the uptick rule makes it an attractive investment to hedge fund managers.

To learn more, see Introduction To Exchange-Traded Funds, How To Use ETFs In Your Portfolio and Active vs. Passive Investing In ETFs.

RELATED FAQS
  1. What does a high turnover ratio signify for an investment fund?

    If an investment fund has a high turnover ratio, it indicates it replaces most or all of its holdings over a one-year period. ... Read Full Answer >>
  2. Does index trading increase market vulnerability?

    The rise of index trading may increase the overall vulnerability of the stock market due to increased correlations between ... Read Full Answer >>
  3. What is the difference between passive and active asset management?

    Asset management utilizes two main investment strategies that can be used to generate returns: active asset management and ... Read Full Answer >>
  4. Is there a situation in which wash trading is legal?

    Wash trading, the intentional practice of manipulating a stock's activity level to deceive other investors, is not a legal ... Read Full Answer >>
  5. What action is the SEC likely to take on 12b-1 fees?

    The Securities and Exchange Commission (SEC) may take action to impose greater regulation on how 12b-1 fees are used, or ... Read Full Answer >>
  6. What is considered a reasonable 12b-1 fee?

    A reasonable 12b-1 fee is generally considered to be 0.25% of the assets of the mutual fund. The maximum amount allowed for ... Read Full Answer >>
Related Articles
  1. Mutual Funds & ETFs

    ETF Analysis: First Trust Dorsey Wright Focus 5

    Take a closer look at the First Trust Dorsey Wright Focus 5 ETF, a unique and innovative fund of funds based on momentum and relative strength.
  2. Mutual Funds & ETFs

    ETF Analysis: iShares National AMT-Free Muni Bond

    Take an in-depth look at the iShares National AMT-Free Municipal Bond ETF, a highly diverse and very popular muni bond fund.
  3. Mutual Funds & ETFs

    Top 5 Bear Market Mutual Funds

    Discover five bear market mutual funds that investors can turn to for generating maximum capital appreciation during a bear market.
  4. Mutual Funds & ETFs

    4 Mutual Funds to Consider If Interest Rates Rise

    Learn what mutual funds will perform best if interest rates rise. Interest rates can rise due to inflation or to an improving economy.
  5. Mutual Funds & ETFs

    Top 3 Switzerland ETFs

    Explore detailed analysis and information of the top three Swiss exchange-traded funds that offer exposure to the Swiss equities market.
  6. Active Trading Fundamentals

    This Is How 3 Investors Made a Billion Dollars

    Read about three major hedge fund managers who are worth at least $1 billion and who made large amounts of money on a single trade idea.
  7. Mutual Funds & ETFs

    7 Best ETF Trading Strategies for Beginners

    Exchange-traded funds are ideal instruments for beginning traders and investors. Learn the seven best strategies for trading ETFs.
  8. Mutual Funds & ETFs

    ETF Analysis: SPDR Dow Jones International RelEst

    Learn how the SPDR Dow Jones International Real Estate exchange-traded fund (ETF) is managed and for whom the ETF is most appropriate.
  9. Mutual Funds & ETFs

    ETF Analysis: iShares JPMorgan USD Emerg Markets Bond

    Learn about the iShares JPMorgan USD Emerging Markets Bond fund, which invests in bonds of sovereign and quasi-sovereign entities from emerging markets.
  10. Active Trading Fundamentals

    How Hedge Funds Front-Run Index Funds to Profit

    Understand what front running is, and learn how hedge funds use this investing strategy to profit from the anticipated stock buys of index funds.
RELATED TERMS
  1. Equity

    The value of an asset less the value of all liabilities on that ...
  2. Exchange-Traded Fund (ETF)

    A security that tracks an index, a commodity or a basket of assets ...
  3. Series 6

    A securities license entitling the holder to register as a limited ...
  4. Bear Closing

    Purchasing a security, currency, or commodity in order to close ...
  5. Exchange-Traded Mutual Funds (ETMF)

    Investopedia explains the definition of exchange-traded mutual ...
  6. Crowded Short

    A trade on the short side with an overwhelmingly large number ...

You May Also Like

Trading Center
×

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!