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Exchange-traded funds are baskets of stocks or bonds that trade like stocks. This means they price continuously throughout the trading day, not just at the market close, as is the case with most traditional mutual funds. Right now, the most popular ETFs follow indexes, which makes them very similar to index-based mutual funds. Standard & Poor's Depositary Receipts (SPY), or Spiders, track the S&P 500 index; Diamonds (DIA) follow the Dow Jones Industrial Average; and the Nasdaq-100 Trust (QQQQ), or Cubes, benchmark the Nasdaq 100 index. And they usually do it at a lower cost than even the most budget-conscious index funds. Case in point: SPDRs cost only 0.10% a year, while the ultracheap Vanguard 500 Index (VFINX) fund is priced at 0.18%.
Tax efficiency is another key quality of ETFs. ETF providers, unlike regular mutual fund managers, aren't forced to sell the fund's holdings when a significant number of shareholders redeem their shares. (Such an exodus can spur a traditional mutual fund to issue a sizable distribution of taxable capital gains). That's not to say an ETF has never handed out a tax hit, although so far this group has done so less frequently than typical mutual funds.
The biggest drawback to ETFs is that they must be purchased through a broker, which means you'll have to pay a commission each time you trade the shares. If you rely on dollar-cost averaging to invest, ETFs will lead you to a hefty brokerage bill.
Currently more than 350 ETFs are available, including those based on specific stock sectors, such as financials, technology, utilities and gold. Also available: ETFs that track the indexes of specific countries ranging from Australia to Taiwan. You can expect to see still more ETFs rolled out each year.
Despite their rapidly growing popularity, ETFs still aren't owned by a broad spectrum of individual investors. But we expect they'll gain popularity as word of their advantages gets out.
Do you crave exposure to foreign indexes? Are your holdings a little heavy in large American companies? Do you think biotechnology is a boom industry, but aren't comfortable committing money to one particular company? There are ETFs to represent virtually any segment of the market -- both here and abroad -- nearly any way you slice it. There are ones tracking everything from bonds, REITs, and the utility sector to the pedestrian Fool favorite S&P 500. If that sounds a lot like the index mutual fund market's offerings, it is. For some investors, though, ETFs are a better fit for their investment dollars.
ETF Questions and Answers
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