ETFs - Exchange Traded Funds

Exchange-Traded Funds, or ETFs, can be mystifying to the most hardened investor. If a mutual fund and a stock were to fall in love and have a baby, ETFs would most likely be the bouncing baby produced. ETFs are like mutual funds that are traded on a stock exchange and can offer significant flexibility to your portfolio.

What is an Exchange-Traded Fund?

An ETF is essentially a financial construct that allows an investor to buy and sell a basket of underlying assets. While the mechanics are quite complex, ultimately ETFs allow you to trade on the value of these assets. For example, the most popular ETF by volume tracks the S&P 500 index, meaning that it will tend to go up or down by roughly the same amount as the S&P 500 index in any given day.

Why Would I Want One?

There are many reasons to be interested in ETFs. One of the reasons might be if you're interested in investing in an asset but don't want to actually take possession of it. Take, for example, oil. If you think the price of oil is going to go up, you could buy one of the many oil ETFs, which should roughly track the price of oil. This is much easier than trading on the futures market, or storing barrels of oil in your garage.

The second reason is similar to why you might want an index fund. As we mentioned, the most popular ETF tracks the S&P 500 index, which means you could buy this ETF and get roughly the same results as buying an index fund. While there are minor differences that we'll discuss later, ETFs can fulfill many of the same roles in your portfolio as index funds.

So What's the Catch?

There are some issues to be considered. One is that ETFs haven't been around very long and thus may not be as well understood. In fact, ETFs biggest downside is likely their amazing diversity. As bankers invent more and more ETFs for us to buy, they may very well come up with some really bad ideas. Thus it's very important to understand the details of an ETF before you buy it, and be very wary of the less popular ETFs.

Even the more popular ETFs can have caveats that you should understand before investing. Be very careful before jumping into the ETF pool. ETFs can be a convenient way to bring balance to your portfolio. We'll talk more about specific ETFs and why you would want to own them later. While they should be approached with caution, ETFs should be a tool in your toolkit.

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