While exchange traded funds have been available for quite some time, it still seems to be partially shrouded in mystery. More recently, ETFs have become a popular means of gaining exposure to broad and niche markets without any complications or expensive fees. To give you a basic idea, in 2001 ETFs held $83 billion in assets. Fast forward eleven years to 2012, where ETF held assets was equivalent to almost $1.2 trillion. There are a variety of reasons why investors choose exchange traded funds over mutual funds or stock trades. For those of you who are still new to the world of ETFs, read on to learn ETF basics, the benefits, and the downsides of trading these semi-understood options. From there, you can take it upon yourself to decide whether or not you’d like to start trading ETFs, easily diversifying your portfolio.

First things first, what exactly is an exchange traded fund?

What Is an ETF?

To put it in the most simple of terms, exchange traded funds are investments that trade openly on the stock exchange. Consider the type of investment that would be produced by combining mutual funds with stock trades. Available in a variety of markets, ETFs can be seen as the best of both worlds as they perfect marry broad portfolio diversification with the ease of a single stock trade on the exchange. Their structure is very similar to mutual funds, as each share an investor purchases represents partial ownership of an underlying group of securities. ETFs were designed to track the performance of stock market indexes. The first ETF to emerge tracked the performance of the S&P 500. Exchange traded funds passively track specific indexes in an attempt to “become” the stock rather than “beat” it. Investors are also drawn to ETFs because they are also able to provide more investing options due to the broad range of indexes they encompass.

Now that you have a better idea of what ETFs are, let’s take a look at the basic similarities and differences between ETFs, mutual funds, and stock trades.

ETF Basics

When it trades like a stock and looks like a mutual fund, you can bet a year’s worth of management fees it’s an ETF. Adding a few exchange traded funds can definitely help you build a well diversified portfolio, but you need to make sure you understand the basic mechanics of this type of investment.

We’ll start with the most major difference between exchange traded funds and mutual funds, which would be how ETFs are bought and sold. Because ETFs trade like stocks, investors can purchase and sell shares regardless of the time of day. Mutual funds however, can only can only be bought or redeemed from the mutual fund company only after the close of trading. Another major difference between the two funds is the fact that there are no sales charges for exchange traded funds, though sometimes they do offer low management fees similar to those you would find with low index funds.

Besides the similarities to stock trades mentioned above, ETFs also offer an assortment of flexible trading options. The two most common are stop orders, which assigns an exact price for ETF shares to be purchased and sold for. Additionally, you also have limit orders where there is a set maximum or minimum price at which you are willing to buy or sell ETF shares for.

Since you know how to tell the difference between the three investment types, let’s take a look at the benefits and risks that accompany exchange traded funds to see if it is really worth investing in.

ETFs for Dummies – Know the Risks and Rewards

An ETFs For Dummies tutorial wouldn’t be complete unless it covers the main risks associated with trading and investing in ETFs to help traders and investors to avoid the pitfalls associated with buying ETFs. The following are the main ETF risks:

• ETF prospectuses should be read carefully to understand how ETFs derive their valuations and the risks associated with holding particular ETF securities.
• Leveraged ETFs that try to capture a 200% or 300% move, based on their underlying assets, are generally not suitable for long term investment purposes. This is due their spotty track records at tracking underlying assets properly over long periods of time and the exaggerated exposure that they subject an investment portfolio to within a specific investment sector.
• ETF securities that invest in futures contracts have the risk of losing value due to price decay, if the futures contracts that are purchased over time by the ETF are more expensive than the near term ones sold by the ETF, which could cause a loss of investment principal over time regardless of the performance of the underlying assets.

Of course, there are also rewards associated with investing in ETFs, and ETFs For Dummies is going to spell them out. ETFs can be particularly rewarding if used to invest in a stock market index, as their fees are considerably less than mutual funds, which increases the potential long term investment gains. ETFs can also be particularly useful when an investor is trying to make a targeted investment, as there are ETFs for a wide variety of investment scenarios. Leveraged ETFs can be useful to traders trying to capitalize and make the most money possible from an anticipated move in a market segment.

Exchange Traded Funds, Now You Know!

While this information is incredibly valuable for gaining an understanding of ETFs, you need to remember to treat them just as you would treat a typical investment. Never purchase anything until you do the necessary research. Make sure you understand exactly what you are investing in and not just simply go for the gusto to diversify your portfolio. Once you’ve done your homework you can determine what ETFs to invest in, and start reaping the benefits of a more tax efficient, transparent investment. Make sure you also use additional resources for any questions that haven’t been answered from this post. As always, good luck!

What are your thoughts about exchange traded funds? Are they worth it? What advice do you have for beginners?

Stay up to date on the latest ETF news by getting on our FREE eMail list!