Exchange-Traded Funds (ETFs) Guide

1. What's an ETF?
Exchange-traded funds sprung onto the investment scene nearly 15 years ago, but they've been stealing the spotlight from their more mature mutual fund cousins in recent years.

More commonly referred to as ETFs, they're basically index funds (mutual funds that track various stock market indexes) but they trade like stocks. As such, they have all of the benefits of plain old index funds with some added punch. Their fees are often cheaper than index funds, though not always, and they may cost you even less in taxes. 

So how exactly are they different? OK, here's the technical gobbledy-gook:

An ETF's underlying net asset value is calculated by taking the current value of the fund's net assets (the value of all securities inside minus liabilities) divided by the total number of shares outstanding. The NAV is published every 15 seconds throughout the trading day. But the ETF's NAV isn't necessarily its market price. More on that in a bit.

When you purchase shares of a traditional mutual fund, the net asset value serves much like a stock price -- it's the price at which shares are bought or sold from the fund company. At a traditional fund, the NAV is set at the end of each trading day.

ETFs, as noted, work a bit differently. Since ETFs trade like a stock, you buy and sell shares on an exchange at a price determined by supply and demand. That's why an ETF's market price can differ from its net asset value. The way ETF shares are structured helps keep the gap between those two figures pretty tight.

Many investors - including the pros - have taken notice of these funds. Money invested in ETFs has more than quintupled over the past five years. The number of ETFs has skyrocketed at the same pace - there are now hundreds to choose from. Sure, that's not quite as many as the thousands of mutual funds that exist - but it is a lot of growth. And there are hundreds more on the way.

What's all the fuss about? They're likable for several reasons:

Costs: There are a lot of good ETFs that have very low fees compared with their traditional mutual fund cousins.

Taxes: ETFs are big winners in the tax department. As with any index fund, the manager of the ETF doesn't need to constantly buy and sell stocks unless a component of the underlying index that the ETF is attempting to track has changed. (This can happen if companies have merged, gone out of business or if their stocks have moved dramatically). And given the special way ETFs are structured (trust us, you don't want to know how this works), they're often more tax-efficient than traditional index mutual funds.

Diversification: Like index funds, ETFs provide an easy way to invest in a specific part of the stock or bond market (say, small-cap stocks, energy or emerging markets), or the whole shebang (like the Standard & Poor's 500).

Open Book: Again, since they track an index, you usually know exactly what's inside an ETF. With traditional mutual funds, holdings are usually revealed with a long delay and only periodically throughout the year, with the exception of traditional mutual funds that track a specific index.

User-Friendly: ETFs can be bought or sold at anytime during the day, just like stocks. Mutual funds, on the other hand, are priced only once at the end of each trading day. If you're investing for the long-term, this doesn't really matter. It is nice to know, however, that you can usually exit an ETF at any time during the trading day.

There is a small catch. Since ETFs trade like stocks, buyers must pay a brokerage commission every time they buy or sell shares (online brokerage commissions range from a few dollars per trade to $20 per trade, depending on the broker LINK to Online Brokerage Guide. That can quickly add up, especially if you're buying more shares each month. ETFs are great for lump-sum investors, but you should use a traditional index fund if you're buying a little bit at a time.

2. Who Should Buy an ETF?
There are a few situations where ETFS come in handy:

  • Like we said, if you have a chunk of money you'd like to invest - say if you're rolling money over from an old 401(k) to an IRA -- ETFs could be a smart choice.

But if you want to regularly build on that investment a bit each month, stick with mutual funds that you're able to buy without paying brokerage fees. Paying a commission will eat into your returns. And there are at least a handful of good mutual funds to choose from that track the big, popular stock indexes.

  • If you don't have the $2,000 minimum investment required by some mutual funds, you can use ETFs as an alternative. A portfolio can be easily assembled with as few as three ETFs, such as: the Vanguard Total Stock Market ETF, which covers the entire U.S. stock market; iShares MSCI EAFE, which tracks the international markets, and the iShares Lehman Aggregate Bond ETF. Our asset allocation calculator will give you an idea of what types of investments you should have.
  • ETFs can perform the same acrobatics that stocks can.You can buy option contractson many ETFs, and they can be shorted or bought on margin.

We don't recommend that you do any of these things as a long-term investor - you should really be a professional acrobat before you get involved with any of these high-wire acts.

3. Getting a Great Deal on an ETF

Step I: Find a brokerage that offers a wide selection of ETFs
You can buy ETFs almost anywhere you can buy a stock - they can be purchased through a broker or a brokerage account. Your best bet is through an online brokerage (like E*Trade, Charles Schwab or Fidelity) with low commissions. Read more about how to find the best brokerage in our investment brokerage guide.

Before you commit to a brokerage firm, however, make sure they offer everything you're looking for. Some smaller outfits may only offer an edited selection of ETFs - though they should offer the most widely-used and easy to trade ones.

Step II: Choose a high-quality ETF that fits into your investment plan
You want to evaluate ETFs the same way you would any other mutual fund.

You should try and answer the following questions: What does the index track, how is it constructed, what's inside and how long has it been around?

While ETFs that track long-standing indexes such as the S&P 500 and Russell 3000 have stood the test of time, many ETF creators are stretching the definition of indexing.

Meanwhile, some have cooked up new indexes that track arcane segments of the market. As a long-term investor, you want to avoid newfangled ETFs that track esoteric benchmarks.

Read our Grilling Guide for advice on how to get this information.

Step III: Consider costs
An expense ratio tells you how much an ETF costs. The amount is skimmed from your account and goes towards paying a fund's total annual expenses. Remember, the expense ratio doesn't include the brokerage commissions you pay to buy and sell ETF shares.

The average ETF carries an expense ratio of 0.44% (that means it'll cost you $4.40 in annual fees for every $1,000 you invest), while the average traditional index fund costs 0.74%, according to Morningstar. On the flip side, there's been a proliferation of more narrowly-focused and exotic ETFs - many of which are not only useless, but much more expensive. Avoid these funds unless you REALLY know what you're doing.

If you're thinking about investing in a lifecycle fund that invests in ETFs check to see if it will charge an extra management fee. Lifecycle funds, also known as target-dated retirement funds, invest in a combination of stocks and bonds funds whose mix becomes gradually more conservative as the investor reaches retirement. You might be better off in a target-date fund that invests in regular index funds and doesn't charge this extra fee. Be sure to do a side-by-side comparison.

Step IV: Consider tax-efficiency
Most ETFs are pretty darn tax-efficient because of the special way they are built. However, some ETFs are mimicking newer indexes that are less static and trade more often. These may trigger more capital gains costs.

Meanwhile, some ETFs invest directly in precious metals, such as gold, are considered "collectibles" and are taxed at a much higher rate. Gains on collectibles are taxed at a maximum rate of 28%, rather than the 15% long-term capital gains rate.

Lastly, don't forget that trading in and out of ETF shares can generate taxable gains, just like stocks.

One More Step: Know the key players and their nicknames:
Different ETF providers call their ETF wares different things:

  • Barclays brands their ETF shares as iShares.
  • State Street calls their products SPDRs (pronounced spiders).
  • Vanguard just calls theirs Vanguard ETFs (they used to be called Vipers).

Other ETFs are so popular they've earned nicknames of their own:

  • Spiders: Not to be confused with State Street's ETF brand, this is the original spider - the first ETF ever - was launched by the same firm in 1993. Officially known as the SPDR S&P 500 ETF (SPY), it tracks the S&P 500 Index.
  • Cubes or Q's: This refers to the widely-traded PowerShares QQQ Trust, which tracks the Nasdaq 100 Index, or the largest 100 non-financial stocks in the Nasdaq Composite Index. The NASDAQ is largely comprised of tech stocks.
  • Diamonds: More formally known as the Diamonds Trust Series I (DIA), this ETF tracks the Dow Jones Industrial Average.

4. Grilling Guide: Questions to Ask When Shopping For an ETF
How long has the ETF and the index it tracks been around?
You really don't want to invest in an ETF that hasn't been around at least three years. If it's younger than that, it's just too soon to tell whether or not it's worth investing in.

With newer ETFs, be wary of "back-tested" results, or results the fund may have achieved in the past if the ETF existed before it actually started trading. Providers can cherry pick the time periods they use in their back tests to make their strategies look good, says Dan Culloton, senior analyst at Morningstar. Barclays Global Investors, State Street Global Advisors and Vanguard are some of the most experienced ETF hands.

How long has the ETF provider been around?
Barclays Global Investors, State Street Global Advisors and Vanguard are some of the most experienced ETF hands. There are some newer players backed by smart people, like WisdomTree, but we'd still wait until their funds have a longer track record before we jumped in.

How is the ETF's index structured?
You can find this information inside the fund's prospectus, which is usually available on the website you're buying the fund on or on the fund company's website directly. Or check the SEC's website.

While ETFs that track long-standing indexes such as the S&P 500 and Russell 3000 have stood the test of time, many ETF creators are stretching the definition of indexing (in fact, some ETFs are beginning to look more like actively-managed mutual funds, complete with higher costs). Meanwhile, some have cooked up new indexes that track arcane segments of the market: PowerShares, for instance, offers an ETF that tracks the performance of companies in the nanotechnology industry. That's pretty narrow - and risky. Others have created ETFs on new methodologies that are still quite young. For instance, WisdomTree Investments offers ETFs that weight companies based on their dividends and earnings.

If you're new to investing and have a limited amount of money to invest, we'd recommend sticking to basic funds that cover wide swaths of the market, such as the Vanguard Total Stock Market ETF, which covers the entire U.S. stock market; iShares MSCI EAFE, which tracks the international markets, and the iShares Lehman Aggregate Bond ETF. There are plenty of other fine ETFs available; these are just a few.

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