DEFINITION of 'Index ETF'

Exchange-traded funds that follow a specific benchmark index as closely as possible. Index ETFs are much like index mutual funds, but whereas the mutual fund shares can only be redeemed at one price daily, the closing net asset value (NAV), index ETFs can be bought and sold throughout the day on exchanges. Through an index ETF, investors get exposure to a large number of securities in a single transaction. Index ETFs can cover U.S. and foreign markets, specific sectors, or a specific class of stock (i.e. small-caps, ADRs, etc.) but all incorporate a passive investment strategy, only making portfolio changes when changes occur in the underlying index.

BREAKING DOWN 'Index ETF'

Index ETFs may occasionally trade at slight premiums or discounts to the fund's NAV, but any differences will quickly be ferreted out through arbitrage by institutional investors. In most cases, even the intraday prices will correlate rather precisely to the actual value of the underlying securities. Additional options are available such as leveraged ETFs or short ETFs, which will have a compound or inverse response, respectively, to the underlying index. Index ETFs can be found based on most of the major indexes such as the Dow Jones Industrial Average, the S&P 500 and the Russell 2000.

Costs are comparable to the cheapest no-load index mutual funds as measured by the expense ratio, but investors will typically have to pay standard commission rates for ETF trades. Mutual fund commission rates are typically lower than for exchange-traded securities.

Index ETFs can be set up as either grantor trusts, unit investment trusts (UITs) or open-ended mutual funds, and will have slightly different regulatory guidelines as a result. Most index ETF shares can be traded with limit orders, sold short and purchased on margin.

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