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This is a basic guide that answers the question, "What is an ETF?"
ETFs, or "exchange-traded funds," are rapidly gaining in popularity among investors. Even after U.S. investors poured record-breaking levels of cash into ETFs in 2013, ETF investing is still more popular than ever.
In March, assets of ETFs (exchange-traded funds) and ETPs (exchange-traded products) in the United States reached a new record high of $1.73 trillion. In the first quarter of 2014 alone, ETFs/ETPs in the U.S. gathered net inflows of $15 billion, with 1,568 ETFs/ETPs listed from 57 providers on three exchanges.
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Here's what ETFs are, and why they are such popular investment tools right now.
What is an ETF: Source of Diversity
An exchange-traded fund is traded in much the same way as stocks. It can hold a variety of instruments in its "basket," such as stocks, bonds or commodities.
There are many ways to invest in market segments. For instance, investors can purchase shares in publicly traded companies, or they can purchase debt securities such as bonds. They can tap into commodities' segments like agricultural, oil, and precious metals.
Investing in individual shares or other instruments can carry a significant amount of risk because it's "putting all your eggs in one basket." For this reason, many investors seek to diversify their portfolios as a protection against loss if one particular type of investment fails to perform adequately.
Here's what sets ETFs apart as an investment tool…
ETFs carry similar diversity advantages that are found in mutual funds, but ETFs are distinct in other ways. For instance, ETFs usually track an index. In comparison to mutual funds, this allows for a more passive management style in which fund managers only need to adjust the funds periodically to keep them on track with their indices. This is quite different from the tasks of fund managers who actively manage mutual funds for optimal gains. That means ETFs generally carry lower administrative fees and costs than do mutual funds.
Investors asking "what is an ETF" should also be aware of the tax advantages of owning ETFs. Because ETFs are passively managed, it is not likely that a large volume of securities trading will occur that would result in capital gains distributions. Because ETFs have fewer trades going into and out of the fund, there are fewer taxable distributions and a higher return on investment.
The final major distinction ETFs have compared to mutual funds is that where mutual funds are only priced at market close, ETFs are priced and traded throughout the day (like stocks). That means ETFs can be bought on margin or sold short.
What is an ETF: Why Track An Index?
In understanding what an ETF is, it's also important to know the concept of a fund that follows an index.
An index is simply a listing of a group of stocks. It serves as a benchmark for ascertaining the value of the stocks contained within.
Some widely-known indices include the Dow Jones Industrial Average, the Standard & Poor's 500, and the Nasdaq Composite. There are also other, lesser-known indices that represent specific market sectors such as technology, health, real estate and energy – these are the indices typically tied to ETFs.
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