November 10, 2008 -

ETF stands for exchange-traded funds. ETF's are a lot like mutual funds but trade throughout the day very much like normal stocks. ETF's are index-based, representing baskets of stocks, bonds or other assets and are often lower-cost than comparable index-based mutual funds.

Unlike open-ended funds, which buy back their own shares, ETF owners can sell their funds to anyone in the stock market who is willing to buy them. Also higher levels of transparency make an ETF investment trade much closer to its actual value than a regular mutual fund.

For a long time mutual funds have made it easy for ordinary investors to invest modest amounts of capital to achieve a diversified portfolio of stocks, but ETF are a new way to achieve that same goal with trading flexibility not found with mutual funds.

ETF Growth

The market for ETFs has been growing very quickly wtih demand driven by both individual investors and professional investors alike:

• As of April 2007 the assets invested in U.S. ETFs totaled $466 Billion, compared to about $10.5 Trillion for mutual funds overall (source: ICI). Total assets invested in ETFs grew 40% in 2006, versus 17% growth for mutual funds.
• There are currently more than 400 ETFs approved by the SEC and trading, and many more coming soonl. The first exchange-traded fund (ETF) was approved by the SEC and launched in 1993.
• ETF growth is largely being driven by individual investors, who value the lower costs and tax advantages, as well as professional investors who value their flexibility and use them in their own portfolio investment strategies.

• When you buy mutual fund shares, you’re buying directly from the fund company which holds the individual securities that make up that fund. When you sell your shares are ‘redeemed’ directly by the mutual fund company based on their Net Asset Value.
  
• When you buy ETF shares, you’re also buying shares that represent fractional ownership of a basket of securities. However, instead of buying or redeeming them from the fund sponsor directly, you buy them on the open market, from ‘market makers.’
  
• Market makers can create or redeem blocks of shares of the ETF at any time by buying or selling the underlying securities. They can also buy or redeem large ETF share blocks directly from the fund sponsor, tendering or receiving the underlying securities in return (an 'in-kind' transaction, which is what makes ETFs tax-efficient).
  
• ETFs are approved and regulated by the The Securities and Exchange Commission.

Low Expense: Mutual funds tend to have the objective to beat a respective index. ETFs are typically managed passively with the objective of matching the performance of their underlying index. Consequently, ETFs are generally able to operate with lower annual operating expenses than their actively managed mutual fund counterparts. These cost savings are then passed along to the investor in the form of lower expense ratios. ETF expense ratios generally range between 0.1% and 1%. Mutual fund expense ratios range from 1% to 3% so it is clear that ETF transaction fees will ordinarily beat mutual funds fees. Ordinary brokerage commissions apply.

Tax Efficiency: The unique structure of ETFs minimizes potential capital gains. Unlike most mutual funds, ETFs trade on an exchange insulating investors from taxable events generated by other investors. Since ETFs do not have to sell securities to cover investor redemptions, this increases tax efficiency while reducing potential capital gains.

Diversification: ETFs offer investors the opportunity to invest in a favorite sector yet avoiding the potentially negative effects a downturn in the market could have on a few individual stocks. ETFs can provide instant, diversified exposure by simply purchasing one security.

Flexibility: ETFs trade continuously throughout each market day. Thus, you can trade ETF's just like you do individual stocks. Shares can be purchased in odd/lots as well as round lots, requiring relatively low investment costs. ETFs are subject to risks similar to those of stocks, including those regarding short selling.

Transparency: The transparency of ETFs can help reduce duplication and help facilitate better tax loss strategies in your portfolio at year end. Since ETFs track a specific index, you have an exact understanding of the underlying securities.

Timing: Mutual Funds give you the end-of-day trade price. ETFs trade all day long so you don't have to wait till 4 PM EST to see what price you get locked in at.

Stock Index ETFs: The most common type of ETF today. These funds are designed to track major stock indexes like the S&P 500 or the Dow Jones Industrial Average. Standard & Poor’s Depositary Receipts (SPY:AMEX), is an ETF that tracks the performance of the S&P 500 as an example.

Bond funds: Another type of investment represented by ETFs. For instance, Vanguard, a source for many low-cost ETFs, offers several bond ETFs. It offers the Total Bond Market ETF (BND), which owns bonds of many different maturities as well as the Short-Term Bond ETF (BSV) and Inter-Term Bond ETF (BIV). iShares, which has been a leader in the area of bond ETFs, offers the broad iShares Lehman Aggregate Bond Fund (AGG) and many specialty bond ETFs, such as the iShares iBoxx High Yield Corporate Bond Fund (HYG). When you buy these bond fund ETFs you get two ways to profit. First, if the value of the bonds owned by the ETFs rise or fall, the share price of the ETF rises and falls. Also when the coupon payments are made by the bonds, those payments are passed on to the bond fund investor in their entirety.

Commodities ETFs: There is a growing selection of commodity ETF's from which to choose these days. Commodities — like oil, gas, grains, and gold — were once a tougher market to get into for small investors. Now commodities plays like the U.S. Oil Fund (USO: AMEX) are providing commodity plays for the average investor.

Managed ETFs: In 2008, the Securities and Exchange Commission decided to allow actively managed ETFs for the first time, meaning that ETFs weren’t relegated to tracking an index or commodity. The first group of actively managed ETFs was put out by PowerShares in July 2008.

Mutual funds generally fall into two categories:

Open-ended fund: These are the most common, as they dominate in both assets and volume traded. Purchases and sales take place directly between the investors and the fund company. The value of the shares are not affected by the number outstanding.

Closed-end fund: These have a set number of shares and do not issue more shares as demand grows. Prices are driven by demand, not the NAV.

ETFs come in three forms:

Exchange traded open-end index mutual fund: Dividends are reinvested on the day of receipt and paid to shareholders in cash each quarter. Securities lending is allowed and derivatives may be used in the fund.

Exchange traded unit investment trust (UIT): These must attempt to fully replicate their specific indexes, limit investments in a single issue to 25% or less and sets weighting limits for diversified and non-diversified funds. They don’t automatically reinvest, and pay cash dividends quarterly.

Exchange traded grantor trust: It looks like a closed-end fund, but the investor owns the underlying shares in the companies and has the same voting rights as a shareholder. Dividends are paid directly to shareholders, not reinvested.

• Greater trading flexibility, since they trade all day just like a stock.
• Fees are generally lower, ETF fees range from 0.07% to 1.25%, while mutual fund fees range from 0.5% to more than 10%.
• Tax advantages for investors, as passively managed funds tend to realize fewer capital gains than actively managed mutual funds.

Level of assets: There is a minimum level of assets needed to make a fund a considerable investment choice. A common level is at $10 million to indicate investor interest.

Trading activity: The higher the trading volume for an ETF the more liquid it is, with a tighter bid-ask spread. You would be best served by choosing an ETF with good trading volumes.

Underlying index/asset: Consider what index the fund is tracking to determine if that is a market segment or sector that you want to be in.

Tacking error: Minimal tracking error is better, meaning the fund is sticking to its underlying index as best as possible.

Market position: The “first-to-market” advantage provides that the first provider to market usually has the best chance of garnering the most assets before the masses gravitate to it.

• iShares Russell 200 Value (IWN)
• iShares S&P/Barra Small Cap 600 Value (IJS)
• iShares Russell 2000 Growth (IWO)
• iShares S&P/Barra Small Cap 600 Growth (IJT)
• iShares S&P Small Cap 600 Index (IJR)
• iShares Russell 2000 Index ETF (IWM)
• iShares Morningstar Small Core ETF (JKJ)
• streetTracks Dow Jones U.S. Small Cap Value (DSV)
• streetTracks Dow Jones U.S. Small Cap Growth (DSG)
• Vanguard Small-Cap ETF (VB)
• ProShares Short Russell2000 (SWM)
• ProShares Short SmallCap600 (SBB)
• ProShares Ultra Russell2000 (UWM)
• ProShares Ultra Russell2000 Growth (UKK)
• ProShares Ultra Russell2000 Value (UVT)
• ProShares Ultra Russell2000 (TWM)
• ProShares Ultra Russell2000 Growth (SKK)
• ProShares Ultra Russell2000 Value (SJH)
• Rydex Inverse 2x Russell 2000 ETF (RRZ)
• PowerShares Zacks Micro Cap (PZI)
• PowerShares Zacks Small Cap (PZJ)
• WisdomTree International SmallCap Fund (DLS)

ETF Analyzer

Here is a great resource to help research your prospective ETF trades:

http://www.etftrends.com/etf-tools/etf-analyzer/