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. Why don't mutual funds trade like stocks?

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  2. Besides stocks, what other asset classes can I invest in through ETFs?

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  3. What exactly is an ETF portfolio?

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  4. In what situations would mutual fund fees be higher than ETF fees?

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