Exchange Traded Funds: A Primer

This article appears in Mutual Funds 2010. Buy this special issue.

While the mutual fund may be Americans' investment vehicle of choice, a similar type of investment -- the exchange-traded fund -- is coming on strong. New ETFs are appearing at a rate of one a day. You can now choose from among 750 ETFs, and their total assets are approaching $1 trillion.

As with mutual funds, quantity doesn’t mean quality. But ETFs have some advantages you should consider. The main advantage of ETFs is cost: ETFs typically hold expenses down, which means more money in your pocket.

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The first ETF available to U.S. investors hit the market in 1993 as a quick way to buy and sell Standard & Poor’s 500-stock index. Now, ETFs exist for every imaginable investment category -- from something as narrow as a single commodity (such as timber) or a single industry (such as health care) to something as broad as the complete domestic blue-chip stock market.

Most ETFs cover familiar categories, such as growth stocks or Treasury bonds. A few, though, are quirky. Some track nanotech¬nology companies and other ridiculously thin slices of the market. However, the largest group of new ETFs consists of income funds that invest in Treasury, corporate, muni¬cipal and foreign-government bonds. These ETFs can be a great deal for investors looking for broad diversification in income-producing investments at a low cost.

Below we compare the similarities and differences between ETFs and mutual funds. TAKE OUR QUIZ to see how much you know about ETFs.

Minimum purchase. Traditional mutual funds come with investment minimums -- often $2,500 or more -- but you can buy ETFs for much less. For example, a share of SPY, an ETF that tracks the S&P 500, costs about $110. Many others sell for much less. Of course, you have to pay a brokerage commission when you purchase an ETF, so it would be expensive to buy a small number of shares. (For example, a $10 commission on a single $40 ETF share would immediately put you 25% behind.) But ETFs allow you to avoid the often-high minimums of mutual funds.

Holdings. Typically, an ETF holds a basket of securities that track the performance of a specific stock index, bond index or other benchmark. So ETFs are much like traditional index mutual funds. ETFs cover all the stock, bond, real estate and other investments that make up complete portfolios.

Pricing. An ETF’s share price changes throughout the trading day, like a stock’s. By contrast, a mutual fund’s price, or its net asset value, is set only once a day, after the market closes. That means it’s possible to benefit from buying or selling an ETF on the dips and peaks of the day, instead of placing an order and then hoping for a favorable price when trading closes. However, such trading is a risky business that’s best left to professionals (who often lose their shirts doing it).

Costs. Because most ETFs follow indexes or simply own the major companies in a particular sector, they are cheap to operate. They don’t have a large staff of managers and analysts, as do many actively managed mutual funds. So the expense ratio of a typical ETF that invests in large growing companies, such as iShares Russell 1000 Growth Index, is a mere 0.20%. That means for every $1,000 you have invested in the fund, you pay just $2 in expenses annually. Actively managed stock mutual funds usually charge more than 0.75%, and often well over 1%. Even traditional index funds usually charge more than ETFs.

Taxes. ETFs are tax-friendly. That’s because ETFs have lower portfolio turnover than regular mutual funds and distribute fewer capital gains. (Many ETFs don’t pass along gains at all because they never change investments.) Although that doesn’t matter if you hold an ETF inside an IRA or 401(k), it will boost your return in a taxable account.

Tracking errors

But some ETFs have problems. One is when an ETF fails to track its index or benchmark. For example, a tracking error can occur when a commodity ETF, such as U.S. Oil Fund (symbol USO) or U.S. Natural Gas Fund (UNG), doesn’t own the actual commodity. Instead, the fund attempts to track the commodity’s market price by trading options and futures -- an inexact science that can be subject to the crosscurrents of the markets.

We think it’s better to find a commodity ETF that actually owns the commodity in question. Alternatively, choose ETFs that buy shares of leading members of the industry. Then you won’t have to worry about tracking.

Some ETFs use leverage, or borrowed money, to return two or three times the price movement of an index or benchmark. Tracking errors occur here, too. For example, while the stock market is up 60% from its bottom, none of the ETFs labeled 3X have made three times that gain (although a few have managed to rise more than 100%). These ETFs are pitched to short-term traders; they’re not for long-term investment plans.

10 Common ETFs you need to know

Most ETFs’ names are lengthy and sound like a regulation or a document. But many have clever three- or four-letter trading symbols, which is how most investors refer to them. For example, CUT is a lumber ETF. (Such names aren’t always so straightforward -- for example, XLK is an ETF that follows tech stocks.)

SPY (Standard & Poor’s depositary receipts) is the largest ETF. It tracks the S&P 500.

GLD owns gold bullion stored in bank vaults. With the soaring price of gold, it has become the second-largest ETF.

JNK holds high-yield “junk” bonds and pays interest every month.

IGOV gives you short- and intermediate-term government bonds from wealthy countries, such as Japan, Germany, France and Canada.

QQQQ (cubes) are interests in the 100 largest stocks listed on the Nasdaq Stock Market. It’s mostly invested in tech, but it also has a slug of health stocks, as well as companies in a few other sectors. It excludes financial stocks.

JXI invests in the largest electric, gas and water utilities around the world and pays a high monthly dividend.

LQD is a fund of high-grade U.S. corporate bonds. It pays interest every month.

DVY invests in the 100 highest-yielding stocks in the Dow Jones U.S. index, which leads it to a heavy concentration in utility and consumer goods stocks. The fund pays a quarterly dividend.

DGT comprises the Dow Jones Global Titans, 50 of the world’s biggest and most famous stocks.

VNQ is one of many ETFs that hold well-known real estate investment trusts.