Exchange Traded Funds (ETFs) combine features of an index fund and a stock traded on a major exchange. Many are inexpensive, with low management fees, and are tax efficient. An ETF is basically a number of stocks packaged to sell as a single equity. Unlike a mutual fund, however, an ETF can be sold at any time through the trading day, just like a stock. ETFs were initially created to provide a trading vehicle which reflected the price of different indexes. The SPDR, known as the "Spider," for example, tracks stocks in the S&P 500, an index of the 500 largest U.S. companies.

Today, there are literally hundreds of ETFs traded regularly on major exchanges, and represent not only stock indexes, but a variety of other industries and business sectors. There are both positive and negative aspects of ETFs, a smart investor should consider both elements before investing.

TUTORIAL: Exchange-Traded Funds

The Pros
The following applies to both domestic and foreign ETFs traded on U.S. markets. Liquidity is a positive aspect of ETFs, meaning an investor can sell his or her holdings with little difficulty and easily retrieve money from the sale. (For more, read ETF Liquidity: Why It Matters.)

Volatility is reduced in an EFT because it embodies a number of stocks in a specific market sector rather than just one. A single stock may be more likely to decline substantially due to some internal management problem, or because of the cost of servicing debt has risen, eroding margins and the bottom line, or from some other misstep or misfortune. Although stocks of an entire sector may suffer a simultaneous price decline, often competitors within the sector may prosper as the bottom line of their business rivals shrink or go red.

Market Orders May be Used
ETFs may be sold through market orders, meaning, stop-loss orders, market or limit orders. These permit investors to trade ETFs as if they were stocks, and provide risk management opportunities and better chances of profitability when day trading. ETFs may also be shorted, meaning they can be sold without ownership at the time of sale and bought back later for delivery to the buyer at a lower price, for a trading profit.

Bond ETFs
Bond ETFs are less volatile and offers a reasonably good means of diversifying holdings into fixed income instruments. These can include U.S. Treasury Bonds, or high-rated corporate bonds, providing stability and safety.

There are more than 600 ETFs currently traded on the exchanges. Among them are large cap ETFs, packages of large corporations with both value and growth potential. Some small cap ETFs are broadly diversified across business sectors, giving investors an "index" fund of selected companies. There are also Real Estate Investment Trusts (REITs), which have been packaged into ETFs as well. REITs invest in shopping malls, commercial real estate, hotels, amusement parks and mortgages on commercial property.

Tax Efficiency
Because ETF shares are bought and sold on an exchange, just like stocks, the transactions take place between investors who either own the ETFs – the sellers – or who want to buy the shares – the buyers. So, there is no actual sale of the securities in the ETF package. If there is no such sale, there is no capital gains tax liability incurred. There are other circumstances, however, in which an ETF must sell some shares from its package, thereby resulting in capital gains. Investors are urged to consult with their tax accountants or attorneys to advise on complex tax matters. (For more, read Beginner's Guide To Tax Efficient Investing.)

The Cons
Commissions and Trading Fees
Experts have argued that ETFs trade as short-term speculations. Frequent commissions and other trading costs, therefore, erode investor returns. (For more, read A Guide To Investor Fees.)

Limited Diversification
Most ETFs, say some experts, do not provide sufficient diversification. Other authorities, with opposing views, say that there are widely diversified ETFs, and holding them for the long term can produce profits.

The Unknown Index Factor
ETFs tied to unknown or untested indexes, are a major negative aspect of investing in these instruments, say many investment advisors.

The Bottom Line
ETFs generally offer a low cost, widely diverse, tax efficient method of investing across a single business sector, or in bonds or real estate, or in a stock or bond index, providing even wider diversity. Commissions and management fees are relatively low and ETFs may be included in most tax-deferred retirement accounts. On the negative side of the ledger are ETFs which trade frequently, incurring commissions and fees; limited diversification in some ETFs; and, ETFs tied to unknown and or untested indexes.

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