Exchange-Traded Fund - ETF

A security that tracks an index, a commodity or a basket of assets like an index fund, but trades like a stock on an exchange, thus experiencing price changes throughout the day as it is bought and sold.

Investopedia Says:
Because it trades like a stock whose price fluctuates daily, an ETF does not have its net asset value (NAV) calculated every day like a mutual fund does.

By owning an ETF, you get the diversification of an index fund as well as the ability to sell short, buy on margin and purchase as little as one share. Another advantage is that the expense ratios for most ETFs are lower than those of the average mutual fund. When buying and selling ETFs, you have to pay the same commission to your broker that you'd pay on any regular order.

One of the most widely known ETFs is called the SPDR (Spider), which tracks the S&P 500 index and trades under the symbol SPY.

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Securities representing Mutual Funds that are traded like stocks on the exchanges. Also called exchange-listed portfolios, exchange index securities, exchange shares, and listed index securities, they are organized as index shares (Unit Investment Trusts (Uits)) or Open-End Management Companies holding baskets of stocks, or as Portfolio Depositary Shares (Depositary Receipts). They differ from Closed-End Funds, which typically trade at substantial premiums or discounts to their net asset values; in the case of ETFs, arbitrage traders exploit and thus largely eliminate pricing discrepancies between the fund shares and the underlying portfolio values. Arbitrageurs and other large investors, such as market makers and institutions, trade in creation units, typically 50,000 share blocks, that are bought and sold "in kind" and are the only way shares can be bought at net asset value (unless, of course, the market price and NAV happen to be equal). ETFs start as creation units and subsequently issue retail shares.

Compared with open-end index funds, ETFs have a number of advantages: Unlike mutual fund shares, which are priced at their net asset values at the end of each day, ETFs can be bought or sold anytime during the trading day at the market price. The stock exchanges generate a number every fifteen seconds that translates the index value into the ETF share value. Like stocks, ETF shares can be traded using Conditional Orders, can be bought on Margin, and can be sold short (exempt from the Short-Sale Rule). Expense ratios are low relative to regular index funds but vary and tend to get lower as ETFs grow in size. Expense savings in any event have to be weighed against commissions and the fact that they occasionally trade at slight discounts or premiums. Dividend reinvestment, easy if not automatic with straight index funds, is more difficult with ETFs, where relatively high share prices, unavailability of fractional shares, and higher brokerage costs for odd lots mean dividends have to be accumulated and then reinvested at what might be a higher price. Dollar cost averaging is less practical with ETFs than straight index funds. Even more than straight index funds, ETFs minimize capital gains taxes. Most trading in ETFs is between shareholders, sparing the fund the need to sell stocks to meet redemptions. Redemptions by large investors are paid in kind, protecting shareholders from taxable events. Capital gains generated when ETFs adjust for changes in their underlying indexes are relatively infrequent. The significant capital gains are realized when the investor sells the ETF, giving the investor control over the timing of taxability. Some popular ETFs being currently traded include: Spdrs, Diamonds, Ishares, and Quebes (Qqq). ETFs, the majority of which are listed on the American Stock Exchange, are reported in a separate table in The Wall Street Journal under Exchange-Listed Portfolios. See also Holdrs.

Security representing a market index and traded on a stock exchange. Exchange-traded funds are similar to index mutual funds but can be bought or sold any time during the day and have lower expense ratios. Two popular ETFs are Standard & Poor's Depositary Receipt (SPIDERS), which started in 1993, and the NASDAQ-100 Tracking Stock Index first offered in 1999.