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Exchange Traded Funds Investing Beginner’s Guide and Overview

written by: Brian Nelson•edited by: Rebecca Scudder•updated: 11/18/2009

Exchange Traded Funds, or ETFs, are a great way to invest in a diverse portfolio of securities. Understanding how these market traded securities fit into your investment portfolio can help lower your risk and increase your profitable returns.

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    What Are ETF / Exchange Traded Funds?

    Exchange traded funds are similar to traditional mutual funds in many ways. Both types of funds offer investors a way to invest in a basket of securities with a single purchase. Both are managed by investment professionals which alleviates the need for the investor to purchase the individual securities.

    However, the key to understanding ETF investing is knowing how ETFs and Mutual Funds are different.

    The key way in which ETFs differ from mutual funds is in how they are bought and sold.

    Regular mutual funds are purchased from the mutual fund company. This results in the issuance of more shares in conjunction with the inflow of money. When mutual fund shares are sold, those shares are redeemed by the mutual fund company which results in the elimination of those shares in exchange for the outflow of money. As a result, the official value, called the Net Asset Value, is always equal to the underlying value of the securities held by the fund. All transactions are therefore priced at the end of the day meaning that the investor gets the same price for their shares no matter what time they enter their order.

    Often, regular mutual funds are sold via a broker or advisor. Mutual funds sold in this manner often carry a sales charge, known as a load. The fund manager generally uses the majority of the proceeds from the load to pay a commission to the selling firm and subsequently, the broker. In the case of a front-load, this fee reduces the amount of money that is actually invested.

    ETFs, on the other hand, trade like the name implies on an exchange. Shares are not redeemed by the ETF company. When an investor wishes to close out their position in an ETF, they sell their shares like they would sell shares of stock. Likewise, purchasing shares is not done via the company that manages the ETF. While the managing company can issue new shares of an ETF, this is only done on an institutional level, and only as necessary for proper trading. Normally, shares of an exchange traded fund are purchased from another investor who is selling them via the stock market.

    For example, an investor wishing to purchase 100 shares of SPY, or SPDR a popular S&P 500 Index tracking ETF, would not call State Street Bank who manages SPY. Instead, the investor would issue a buy order like they would for a standard stock purchase using the ticker symbol SPY. All of the same options apply, including limit orders, stop orders, and stop-limit orders. In fact, this extra flexibility is one of the many advantages of trading ETFs.

    While the investor does pay a normal trading commission for their purchase, this is likely to be far below what a similar sized purchase of a loaded mutual fund would cost for all but the smallest of trades.

    Look into ETFs as a way to increase your market based trading options and diversify your portfolio.