June 15: What is an ETF and what does it have to do with an Index

by David Jenyns on June 15, 2007

ETF stands for Exchange Traded Fund. Exchange Traded Funds are Collective Investment schemes. Collective investment schemes are ways of investing money with other people in order to participate in a wider range of investments. Collective investments schemes are usually referred to as Mutual Funds, Managed Funds or simply Funds. These funds account for a large portion of the trading on most stock exchanges.

While the structure of ETF’s vary around the world, major common features include:

An exchange listing and ability to trade continually.

They are often index linked instead of being actively managed.

These qualities give ETF’s some advantages over Mutual Funds in the US. ETF’s allow for a diversified portfolio at a low cost. They can be used in both long term buy and hold and for selling short and hedging strategies.

Typically ETF’s replicate a stock market index, such as Standard and Poor’s 500, or the Hang Seng index. They may also contain stocks from a specific market sector such as energy, or a commodity such as gold. They often have amusing or catchy, upbeat names like, “Diamond” and “Spider”. ETF’s are most commonly found on the AME or American Stock Exchange.

Today’s ETF’s Present an alternative to the traditional open ended Mutual Funds. The Open ended index funds are particularly good for this type of use.


The first ETF was introduced on the Toronto Stock Exchange in 1989. There are now over one hundred ETF’s traded on the American Stock Exchange (AME) Since the introduction of SPY on the AME in 1993, ETF’s have become increasingly popular, because they offer the diversification benefits of a Mutual Fund with the features of stock. As more and more ETF’s become available, it is likely their popularity will increase even more. ETF’s typically have lower expense ratio’s and lower turn-over rates than actively managed Mutual Funds, and this can lead to them being more tax-favorable in the United States.

ETF’s Versus Mutual funds

Mutual Funds do have an advantage for people who practice dollar cost averaging, or like to invest a little bit of money every month. Since ETF’s are traded on the stock market every trade has commission costs. Many Mutual Funds do not have such costs. For investors who like to invest 100 USD a month, a Mutual Fund may be cheaper.

There are however many advantages to ETF’s and those advantages are likely to increase over time. ETF’s typically have a lower expanse ratio than actively managed mutual funds, which may charge 1-3% or more. Index funds are usually much lower and ETF’s are typically in the .1-1.5 range. Over the long term these costs can make a sizable difference.

ETF’s can also be more tax efficient. In the US when ever a Mutual Fund realizes a capital gain, it must distribute it to the shareholders at the end of the quarter. These gains are taxable. Since ETF’s are not redeemed by holders and are instead simply sold on the stock market, investors only realize capital gains when they sell their shares.

The most subtle and likely the most important benefit of an ETF is that it acts like stock. Investors can carry out the same sort of trades that they can with a stock. Investors can sell short, use a limit order, a stop loss order, buy on margin and invest as little money as they wish, since there is no minimum investment requirement. Mutual Funds, of course do not offer those features.

For example, an investor in a mutual fund can only purchase or sell at the end of the day at the mutual funds closing price while an ETF is continually priced during the day, so it is not subject to this disadvantage.

Particularly for those investors who know and follow certain indexes and want a diversified portfolio they can trade with, ETF’s offer advantages and afford ability.

For many ETF’s you only need to get a discount brokerage account, and many will let you buy just one single share to start with. It’s easy to see why they are popular. They are deceptively easy and seem simple to acquire, and for those investors who do more trading than buying in holding, they can be much easier to use. But before you invest make sure they are for you.

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