Exchange Traded Funds, also known as ETFs,
have grown greatly in popularity in recent years.
In this article we’ll look at what they are, what are
their benefits, and possible uses in your

An Exchange Traded Fund, or ETF for short, is a fund
whose shares represent the value of a basket of
numerous other stocks, bonds, or commodities, but
trades with its own value on a stock exchange. It can
be bought or sold at any time like any other stock on
the exchange, and its value changes continuously like
any other stock. One can also buy it on margin or sell
it short like any other stock. Historically, these funds
have been created to replicate the value of various
indexes, such as the Dow Jones Industrial Average or
S & P 500. More recently they have been constructed
with a wider range of assets, such as commodities, or
particular type of stocks. However, they generally still
stick to one asset class.   

An ETFs appeal lies primarily in that one can get the
approximate investment performance of an entire
investment class of the market while buying only one
security. This makes it easier for an individual or
institution to pursue various investment strategies. For
instance, diversification is much simpler because the
ETF may inherently be diversified with an indices
stocks. And there is less need for the investor to buy
and sell stocks continuously to achieve diversification.
With an ETF less action will be needed. It also
reduces transaction costs in buying / selling one
security as opposed to buying many securities to
replicate the same performance.

In many ways, an ETF serves the same function as
buying a mutual fund, but there are some important
differences. A mutual fund is an actual measure of the
addition (less fees) of the value of the underlying
stocks. However, an ETF has its own value in the
stock market as it is bought and sold independently of
the underlying stocks. It doesn’t have to match the
exact value of those stocks.  Of course, in most cases
it will be close to that value. It is kept close by
arbitrageurs who buy and sell the underlying securities
in the fund vs. the ETF itself.

Beyond this, mutual funds can only be bought and sold
at the end of the day. ETFs can be bought and sold at
any time during the day - directly in the market. So this
provides the necessary flexibility to be used for
various portfolio purposes.

The long-term performance of an ETF could,
theoretically, be better than a similar mutual fund index
fund because their costs are lower. Their costs are
lower for several reasons. First, the portfolio stock
selection process is greatly simplified since it is only
replicating an established index. Second, the
transaction expenses are lower. There is less of a
need to adjust the portfolio because the components
of the indices change more slowly than other actively
managed funds. Also, adjustments to their portfolio
are done with in-kind transactions with institutions.
Since there is less selling of stocks, there are lower
capital gains expenses experienced overall. In
addition, there are no redemptions to pay out directly
as with a mutual fund. An investor simply sells his/her
ETF shares in the market. The fund itself doesn’t need
to sell the underlying stocks to meet a redemption,
lowering the capital gains expense incurred to the
fund. However, the tax implications may not be
relevant when comparing ETFs to tax-deferred
account mutual funds.     

ETFs also avoid other issues inherent with mutual
funds such as investment companies arbitrarily
allocating performance of underlying stocks to
different funds, possibly to the detriment of your fund.
On the other hand, ETFs may be more volatile than
owning the equivalent stocks. Unless one is looking to
profit through arbitrage with the ETF and the stocks,
this may not be desirable. In which case a mutual fund
may be safer way to go for shorter term performance.
Mutual funds should be a more representative of the
exact performance (less fees) of the stocks it owns.

Beyond this, what role does an ETF play in your
portfolio? One can use it to modify or change the risk
in your overall portfolio. By investing a certain amount
in ETFs, one can bring your overall risk more or less
in line with the overall stock market. For example, if
your other stocks are higher growth, higher risk than
the market, then a given investment in the ETF can
bring the growth and growth down the curve towards
the overall market, in proportion of the investment in
the ETF to your total investment in the market. It’s an
easy way to adjust your overall risk profile with just a
few transactions.

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Exchange Traded Funds: What They Are
and How You Can Use Them. Pros and
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