The exchange traded fund (ETF) market has exploded over the last several years in both the number of funds available and in the quantity of assets underlying them. This explosion can be attributed to four key benefits:

1. They are inexpensive.
2. They are flexible.
3. They are tax efficient.
4. They are transparent.

This article is meant to introduce the reader to the basics of this investment vehicle by comparing them to open end mutual funds.

The Basics

Like mutual funds, ETFs are baskets of securities that are pooled together and provide a diversified exposure to a desired investment objective or category. Moreover, they help investors who do not possess the time and/or skill to successfully select their own individual stocks and/or the investor who is looking for index-like products to use in an asset allocation or index strategy.

The process of cataloging ETFs can be daunting due to their proliferation and overlapping characteristics. Below are ten broad and common categories.

EFT Categories by Percentage of Assets (as of 1/14/10)
Source:  Bloomberg

REITS, 1.5%
Allocation Strategies, 0.1%
Commodity, 8.7%
Currency, 0.8%
U.S Equity, 36.0%
U.S. Sector, 8.5%
Fixed Income, 13.7%
Global/International Equity, 24.8%
Global/International Sector, 2.3%
Leveraged/Inverse, 3.6%

TOTAL = 100%

Unlike mutual funds, ETFs trade throughout the day and their price fluctuates based on supply and demand. Like stocks, ETFs can trade with market orders, limit orders and stop loss orders. They can be purchased on margin (borrowing money to buy stock), and they also can be sold short (selling stock you do not own).

1.  They are inexpensive

ETF providers deal directly with a few large sponsors, thereby eliminating many administrative costs, call centers, and the servicing of small accounts that mutual funds must deal with. The reduction in overhead expenses is then passed along to the investors.

2.  They are flexible

Because ETFs can trade throughout the day, they offer more flexibility than mutual funds. Mutual fund share prices are set once at the end of the trading day. The buy and sell orders placed throughout the day are then executed at this price. ETFs, on the other hand, allow investors to buy and sell shares throughout the day.

In addition to trading flexibility, ETFs also provide investors with broader access to investment categories and to specific sectors of both the domestic and global markets.

3.  They are tax efficient.

ETFs are more tax efficient than mutual funds both at the investor level and at the fund level and are less likely to make taxable capital gain distributions. Their ability to minimize taxes is mainly due to how ETFs are structured to create and redeem shares. A traditional mutual fund will usually experience a tax event from selling portfolio securities in the open market. In contrast, ETFs use an “in-kind” process by exchanging a basket of securities to create and redeem shares. In the U.S., this transaction is not taxable from the fund’s perspective, and there is no distributable gain on the redemption.

4.  They are transparent.

ETFs are not susceptible to the kind of trading abuses and scandals that mutual funds have recently experienced because they trade throughout the day. Their prices are set by market supply and demand, so there is no chance for late trading abuse, however, they can trade at a discount or premium to the fund’s underlying asset values.

In summary, ETFs are an excellent investment vehicle for investors to use in implementing their various investment strategies. They are appropriate for index trackers (beta seekers), for investors trying to outperform a specific benchmark (alpha hunters), and for those who are seeking to increase returns and reduced risk through asset allocation strategies (modern portfolio theorist).