Exchange-traded funds combine the flexibility of a stock with low costs of a mutual fund, but unlike a managed mutual fund, most ETFs are based on stock indices.
Their prices are therefore constantly changing.
BREAKING DOWN 'Exchange-Traded Fund (ETF)'
An ETF is a type of fund which owns the underlying assets (shares of stock, bonds, oil futures, gold bars, foreign currency, etc.) and divides ownership of those assets into shares. The actual investment vehicle structure (such as a corporation or investment trust) will vary by country, and within one country there can be multiple structures that co-exist. Shareholders do not directly own or have any direct claim to the underlying investments in the fund; rather they indirectly own these assets.
ETF shareholders are entitled to a proportion of the profits, such as earned interest or dividends paid, and they may get a residual value in case the fund is liquidated. The ownership of the fund can easily be bought, sold or transferred in much the same was as shares of stock, since ETF shares are traded on public stock exchanges.
Advantages of ETFs
- By owning an ETF, investors get the diversification of an index fund as well as the ability to sell short, buy on margin and purchase as little as one share (there are no minimum deposit requirements).
- Another advantage is that the expense ratios for most ETFs are lower than those of the average mutual fund. When buying and selling ETFs, you have to pay the same commission to your broker that you'd pay on any regular order.
- There exists a potential for favorable taxation on cash flows generated by the ETF, since capital gains from sales inside the fund are not passed through to shareholders as they commonly are with mutual funds.