What Are Exchange-Traded Funds (ETFs)?

By Pinyo, on July 26, 2007

What Are Exchange-Traded Funds (ETFs)? They are essentially a hybrid between individual stocks and mutual funds with characteristics of both. After some research on Yahoo! Finance and About.com, here are some highlights of Exchange-Traded Funds:

ETFs are similar mutual funds

• ETFs are portfolios of many stocks, but their prices do not necessary match the net asset value (NAV) of the underlying stocks. It could be traded at a premium above the NAV, or at a discount below the NAV.
• ETFs are usually set up in categories similar to mutual fund — i.e., small-growth, mid-blend, large-index, specialty-real estate, international, etc.
• ETFs have expense ratio, but usually much lower than mutual funds of the same asset class.

ETFs are similar individual stocks

• ETFs can be traded throughout the day.
• Traders can short or buy ETFs on margin.
• Brokers charges trade commission to buy and sell ETFs.
• ETFs suffer from bid-ask spread, meaning you have to buy at a higher ask price and sell at the lower bid price; effectively, losing the 1/8 spread.

Moreover, ETFs are more tax-efficient than mutual funds. You can see the chart below — the big drop in HFCGX value is the huge distribution at the end of 2006. Luckily, this fund was in my IRA, so no tax!

Why I Like Exchange-Traded Funds (ETFs)?

In the post How Expense Ratio Affect Long-Term Performance?, I showed you how investing in mutual funds with high expense ratio can cost you 50% of your potential gain. With this in mind, I went back to review my IRA portfolio and found a fund that charges 1.23% (above my 1.0% maximum tolerance). This does not seem expensive, but it can cost me 30% of money invested if I keep it in the fund for 30 years. Also, as I mentioned earlier, ETFs tend to be more tax efficient than equivalent mutual funds making them more appealing in a taxable account.

Right now, I have enough money invested such that it is more expensive to invest in mutual funds than ETFs. So today, I went ahead and sold HFCGX and traded it for VB.

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Pinyo is the brain behind Moolanomy personal finance blog and a few other web sites. If you like this article, please subscribe for free daily email updates.

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1. Understanding ETF- What is an ETF and How Does it Work? | Financial Highway