Frequently Asked Questions About Exchange-Traded Funds

By Sree Vidya Bhaktavatsalam

What is an exchange-traded fund?

An exchange-traded fund, or ETF, is an investment product representing a basket of securities that track an index such as the Standard & Poor's 500 Index. ETFs, which are available to individual investors only through brokers and advisers, trade like stocks on an exchange.

How does an ETF differ from an index mutual fund?

Index mutual funds also track baskets of securities. Unlike index funds, which are priced once after the end of each trading session, ETF prices change throughout the day because they're traded like shares. Like shares, they can also be sold short -- a bet that the index value will decline -- and bought on margin using borrowed money.

What are the advantages and disadvantages of ETFs versus mutual funds?

Exchange-traded funds charge lower fees than actively managed mutual funds and offer investors a wide range of sectors, geographies and strategies. Investors in ETFs pay average annual expenses of $25 for every $10,000 of assets, compared with $91 for actively managed U.S. stock funds, according to Morningstar Inc. in Chicago. Investors pay a brokerage fee when they buy or sell ETFs, a drawback for active traders. Commissions can range from as little as zero for certain customers to $25 a trade.

How do investors use ETFs?

ETFs are popular among institutional investors to make rapid and large bets on sectors such as oil, gold, waste-management and semiconductors. They also use ETFs to hedge their bets on stocks, bonds, commodities and other securities. In 2007, managers introduced ETFs for use in retirement accounts such as 401(k) plans, as well as life-cycle ETFs, which invest more conservatively as investors approach retirement. For individual investors, ETFs offer a wider selection of indexes than mutual funds.

What are actively managed ETFs?

Active ETFs are designed to trade on an exchange like stocks, while investing in securities picked by a portfolio manager or by mathematical models. Managers including Invesco Plc and Barclays were the first to receive approval from the U.S. Securities and Exchange Commission in 2008 for actively managed ETFs.

How much is invested in ETFs?

Assets in U.S. exchange-traded funds totaled $731.7 billion as of Jan. 31, 2010, up 48 percent from a year earlier, according to Washington-based trade group Investment Company Institute.

Who are the major sellers of ETFs?

BlackRock Inc. became the biggest seller of exchange-traded funds after its December 2009 purchase of Barclays Plc's iShares unit. IShares manages about $360 billion of ETF assets, giving it a 48 percent share of the U.S. ETF market as of Jan. 31, 2010, according to Morningstar. State Street Global Advisors, with $175 billion of ETF assets, is the second-biggest seller of ETFs. Vanguard ranks third, with $92 billion of ETF assets.

What are some of the biggest ETFs?

The three biggest exchange-traded funds as of Dec. 31, 2009, were the $85 billion S&P 500 SPDR, the $40 billion Gold Shares SPDR, both managed by State Street, and the $39 billion iShares MSCI Emerging Markets ETF, according to data compiled by State Street.