Etf basics

In recent years, exchange-traded funds-commonly referred to as ETFs-have grown in popularity. For many investors, though, ETFs remain something of a mystery. With that in mind, here's an explanation aimed at demystifying ETFs and helping you decide whether they're a good fit for your portfolio.

Generally speaking, you can think of an ETF as a hybrid that blends the investment characteristics of an index mutual fund with the trading characteristics of stock shares.

"Since their inception in 1993, exchange-traded funds have grown rapidly as a convenient, low-cost means of gaining exposure to broad and niche markets," said Joel Dickson of Vanguard Investment Strategy Group.

"At the end of 2001, ETFs held a total of $83 billion in assets. By early 2012, that figure had soared to nearly $1.2 trillion," Mr. Dickson said, citing data from Simfund. "ETFs began as investments that facilitated intraday trading of broad segments of the markets. As time has passed, ETF providers have sliced and diced markets into increasingly smaller fragments."

How ETFs are like index funds Like index funds, most ETFs seek to track specific benchmarks and hold broadly diversified baskets of stocks and bonds. ETFs let you invest in an entire stock market or small segments of it. You can also buy ETFs that represent the entire bond market, international stocks and bonds, or specific industries or market sectors.

While most ETFs follow an indexing strategy, some are actively managed, use borrowed money (leverage), or invest in gold or currencies.

As with any investment, you should do a little homework before you buy. Many ETFs feature expense ratios on par with those of low-cost index funds. For example, Vanguard Total Stock Market ETF had an expense ratio of 0.05% in its 2011 fiscal year. The average expense ratio for ETFs across the industry (0.55%) is far lower than for mutual funds (1.12%), according to Lipper Inc. data as of December 31, 2011.

ETFs can also be very tax-efficient. Like mutual funds, ETFs must distribute income and realized capital gains annually, and these distributions are taxable to investors outside of tax-advantaged accounts. However, thanks to the low-turnover, buy-and-hold nature of the index approach, ETFs-like broad-based index funds-generally tend to distribute only modest capital gains, if any.

"ETFs can also be more efficient than traditional funds at reducing capital gains liability because they've been set up to take advantage of an in-kind redemption process," Mr. Dickson said. "In essence, redeeming shareholders receive securities instead of cash. The fund receives no gains from those transactions. This approach is available to traditional mutual funds as well, but it's not used as often.

"Vanguard developed our unique share class structure, in which the ETF is a separate share class of a traditional mutual fund, with an eye toward tax efficiency," he said. "Combining multiple share classes gives the fund a larger pool of assets, which can lead to broader diversification and lower costs, which in turn can lead to better pre-tax outcomes, in our view.

"This structure also helps us optimize the tax impact of fund redemptions," Mr. Dickson added. "Our goal is to maximize the realization of losses in the traditional share classes and remove positions with large unrealized gains through the in-kind mechanism for the ETF share class."

How ETFs are like stocks As with stocks, ETFs trade on an exchange. Shares can be bought and sold through a brokerage firm at any time during the trading day at the current market price. The net asset value (NAV) of a mutual fund, in contrast, is determined once a day after the market closes.

"Because ETFs trade on an exchange, there are some differences in flexibility in pricing between traditional mutual funds and ETFs," Mr. Dickson said. "With ETFs, if you want to buy only one share, you can buy that share at an intraday price, whereas with a traditional mutual fund there are often minimum investment requirements, and you get whatever the price happens to be at that day's market close, regardless of where the market has gone during the day."

Many investors find the flexibility of ETFs attractive, but there's reason to be cautious about frequent trading.

An ETF's price is determined not only by the securities it holds but by the factors of supply and demand in the market. Thus, ETFs may trade at prices above or below the net asset value of their holdings, meaning you could pay more or less than NAV when buying an ETF, or receive more or less when selling one. (It's worth noting, though that a built-in arbitrage mechanism is designed to keep the price of a domestic ETF share fairly close to its NAV.) There is also the hidden cost of the bid-ask spread-the difference between the price a dealer is willing to pay for a security (the bid price) and the somewhat higher price at which the dealer is willing to sell it (the ask price).

ETFs share additional aspects of stocks' trading flexibility. You can place limit and stop orders, sell short, and buy on margin. Further, many large brokers have eliminated commissions to buy and sell ETFs.