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.

  1. How do hedge funds use equity options?

    With the growth in the size and number of hedge funds over the past decade, the interest in how these funds go about generating ... Read Full Answer >>
  2. Can mutual funds only hold stocks?

    There are some types of mutual funds, called stock funds or equity funds, which hold only stocks. However, there are a number ... Read Full Answer >>
  3. How do mutual funds compound interest?

    The magic of compound interest can be summed up as the concept of interest making interest. On the other hand, simple interest ... Read Full Answer >>
  4. Do mutual funds pay interest?

    Some mutual funds pay interest, though it depends on the types of assets held in the funds' portfolios. Specifically, bond ... Read Full Answer >>
  5. Why have mutual funds become so popular?

    Mutual funds have become an incredibly popular option for a wide variety of investors. This is primarily due to the automatic ... Read Full Answer >>
  6. Who do hedge funds lend money to?

    Many traditional lenders and banks are failing to provide loans. In their absence, hedge funds have begun to fill the gap. ... Read Full Answer >>
Related Articles
  1. Investing

    2 Common Ways to Misuse Target Date Funds

    The world of asset classes is just as complicated as taking vitamins. How much should you take of small caps? Intermediate bonds? Emerging market stocks?
  2. Term

    Understanding Short Covering

    Short covering is buying back borrowed securities to close an open short position.
  3. Mutual Funds & ETFs

    What Target-Date Funds Can Teach About Investing

    Target-date funds are a popular way to invest for retirement. Here's what they can teach the novice investor.
  4. Investing

    The ABCs of Bond ETF Distributions

    How do bond exchange traded fund (ETF) distributions work? It’s a question I get a lot. First, let’s explain what we mean by distributions.
  5. Mutual Funds & ETFs

    4 Mutual Funds Warren Buffet Would Buy

    Learn about four mutual funds Warren Buffett would invest and recommend to his trustee, and discover detailed analysis of these mutual funds.
  6. Mutual Funds & ETFs

    Passively Managed Vs. Actively Managed Mutual Funds: Which is Better?

    Learn about the differences between actively and passively managed mutual funds, and for which types of investors each management style is best suited.
  7. Professionals

    How to Navigate Taxable Mutual Fund Distributions

    It's almost time for year-end capital gains distributions for mutual funds. Here's how to monitor them and minimize their tax impact.
  8. Investing Basics

    Top Tips for Diversifying with Exotic Currencies

    Is there an opportunity in exotic currencies right now, or are you safer sticking to the major ones?
  9. Mutual Funds & ETFs

    The 3 Biggest Mutual Fund Companies in the US

    Compare and contrast the rise of America's big three institutional asset managers: BlackRock Funds, The Vanguard Group and State Street Global Advisors.
  10. Investing Basics

    3 Alternative Investments the Ultra-Rich Usually Own

    Learn about the ultra rich and what normally comprises their net worth; understand the top three alternative investments usually owned by the ultra rich.
  1. Alpha

    Alpha is used in finance to represent two things: 1. a measure ...
  2. Equity

    Equity is the value of an asset less the value of all liabilities ...
  3. Exchange-Traded Fund (ETF)

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

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

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

    Investopedia explains the definition of exchange-traded mutual ...

You May Also Like

Hot Definitions
  1. Purchasing Power

    The value of a currency expressed in terms of the amount of goods or services that one unit of money can buy. Purchasing ...
  2. Real Estate Investment Trust - REIT

    A REIT is a type of security that invests in real estate through property or mortgages and often trades on major exchanges ...
  3. Section 1231 Property

    A tax term relating to depreciable business property that has been held for over a year. Section 1231 property includes buildings, ...
  4. Term Deposit

    A deposit held at a financial institution that has a fixed term, and guarantees return of principal.
  5. Zero-Sum Game

    A situation in which one person’s gain is equivalent to another’s loss, so that the net change in wealth or benefit is zero. ...
  6. Capitalization Rate

    The rate of return on a real estate investment property based on the income that the property is expected to generate.
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!