Exchange-Traded Funds: In a Class by Themselves

Relative Newcomer Now Enjoying Widespread Popularity

When they debuted almost 20 years ago, exchange-traded funds were like the new kid at school — a little mysterious and not very popular. Today, ETFs are enjoying widespread popularity among investors of all kinds. In 2010, the combined assets of the nation’s ETFs topped more than $800 billion.¹

ETFs are unique investments in that they resemble mutual funds but are priced and trade like individual stocks. Why would you consider an ETF when it shares similarities with stocks and mutual funds? Actually, it’s some of the differences that many investors find appealing.

Trading Flexibility, Potentially Lower Expense Ratios, Tax Efficiency

ETF shares can be bought and sold on an exchange throughout the trading day, just like individual stocks, whereas mutual funds are priced once a day after the markets close. This enables you to lock in an ETF share price immediately if it seems favorable. You also have the ability to place market, stop-loss, and limit orders on ETFs, just as you can with stocks.

ETFs that are passively managed generally have lower expense ratios because trades typically occur only when an underlying index changes its makeup. Although you must pay a brokerage commission each time you trade ETF shares, you may pay less in overall operating fees and expenses. Because of an ETF’s structure, you generally incur capital gains tax liability only when you sell your shares, assuming you sell them for a profit. (However, an ETF may distribute capital gains if the composition of the underlying assets changes.)

Another Way to Diversify

Like a mutual fund, an ETF is a portfolio assembled by an investment company. The underlying assets are not chosen randomly but may be selected to track a particular industry, sector, market index, or asset class, or they may share other common traits. In this way, ETFs offer the opportunity to target a specific type or class of security or investment. This allows you to choose the amount of risk you are willing to assume. And because ETFs may hold dozens to hundreds of securities, they offer a level of diversification that you might find cost-prohibitive to replicate. Diversification does not eliminate the risk of loss; it is a method used to help manage investment risk.

ETFs offer some appealing characteristics, but they are not appropriate for everyone. A decision to own them should begin with a thorough review of your circumstances, risk tolerance, and long-term objectives.

The principal value of ETFs, mutual funds, and stocks will fluctuate with changes in market conditions. Supply and demand may cause ETF shares to trade at a premium or a discount relative to the value of the underlying shares. Shares, when sold, may be worth more or less than their original cost.

Exchange-traded funds and mutual funds are sold by prospectus. Please consider the investment objectives, risks, charges, and expenses carefully before investing. The prospectus, which contains this and other information about the investment company, can be obtained from your financial professional. Be sure to read the prospectus carefully before deciding whether to invest.

1) Investment Company Institute, 2010 (data through August 2010)

The information in this article is not intended as tax or legal advice, and it may not be relied on for the purpose of avoiding any federal tax penalties. You are encouraged to seek tax or legal advice from an independent professional advisor. The content is derived from sources believed to be accurate. Neither the information presented nor any opinion expressed constitutes a solicitation for the purchase or sale of any security. This material was written and prepared by Emerald. © 2011 Emerald Connect, Inc.