ETFs: What You Need to Know

What looks like a mutual fund but can be bought and sold on an exchange and traded like a stock? An ETF.

ETFs, or exchange-traded funds, have surged in popularity over the last few years. Since the launch of the first U.S.-based exchange traded fund in 1993, the number of ETFs in the U.S. has ballooned. There are now more than 1,800 representing more than $2.1 trillion of assets according to data from ETF.com, which reports on ETFs.

"ETFs are entering the mass adoption phase," said Matt Hougan, the CEO of ETF.com.

While most "ETFs" are in fact "funds," there are other exchange-traded products, or ETPs, that are often called ETFs but actually fall into the broader ETP category. These can include ETPs offering exposure to commodities or currencies, for example. Even so, "ETF" is commonly used as shorthand to refer to all of these products, which is the approach in this article.

This past summer, ETFs made headlines. During a period of market volatility on Aug. 24, when the Dow Jones Industrial Average tumbled more than 1,000 points in the first few minutes after the market opened, a number of ETFs experienced sharp declines -- some of which far outpaced the overall market's downward move with prices far lower than the sum of their underlying investments.

With ETFs becoming ever more popular, it pays for investors to know both how they work and the potential risks of investing in them. To that end, here is a list of answers to a few frequently asked questions about exchange-traded funds.

How do ETFs work?Like mutual funds, ETFs are typically baskets of stocks, bonds, and other assets, or sometimes just a single asset such as gold. And like their mutual fund brethren, ETFs can offer investors the opportunity to invest in a professionally managed, diversified portfolio of investments.

But there's a key difference. A mutual fund is only priced once a day -- at the end of the day -- based on the closing value of the fund's underlying holdings (known as its net asset value, or NAV). An investor who wants to buy or sell shares of a mutual fund can submit an order at any time during the day but that order will not be executed until the end of the day at the mutual fund's determined NAV.

An ETF, on the other hand, can be bought or sold at any time during the trading day on an exchange, and its price, which can fluctuate significantly, is driven by market forces and the value of its underlying portfolio. ETFs have bid-ask spreads just like stocks, so investors generally get prices that can differ from the underlying portfolio value.

Another difference is that, unlike with mutual funds, investors do not buy shares directly from the fund manager. Instead, an ETF contracts with financial institutions -- called "authorized participants" -- that create and redeem shares from the ETF and sell them to investors on public exchanges.

Investors can buy or sell ETFs on public exchanges throughout the trading day just like stocks through a brokerage account using the same types of orders that are placed for shares of stock. The unique authorized participant/share create-and-redeem structure of ETFs is designed to keep an ETF's market prices close to the value of its underlying portfolio.

Most ETFs are "funds" registered with the Securities and Exchange Commission as investment companies under the Investment Company Act of 1940, and the shares they offer to the public are registered under the Securities Act of 1933.

Some ETFs that invest in or offer exposure to other assets, such as commodities or currencies, are not registered investment companies (and are not really "funds"), but the shares they sell are registered under the Securities Act.

Still another variation, exchange-traded notes, or "ETNs," are similar in some ways to ETFs, but rather than holding an underlying portfolio of assets, they are debt issued by a financial institution and simply represent a promise to pay investors a return linked to the performance of an index or benchmark at a set maturity date.

What types of ETFs are out there?ETFs come in multiple flavors, offering investors exposure to a wide array of markets, industry sectors, regions, asset classes, and investment strategies.

Most ETFs track a particular market index such as the S&P 500. These ETFs are similar to index mutual funds, which likewise track the performance of a specific market benchmark or other index. Some of the most actively traded ETFs track the most familiar market benchmarks: the SPDR S&P 500, the SPDR Dow Jones Industrial Average ETF, and the Invesco PowerShares QQQ, which tracks the Nasdaq 100 Index.

Index-based ETFs aren't trying to beat a particular index. Rather, they're simply trying to match its performance. They do that by investing either in the same stocks and bonds or other assets represented in the index, in the same proportions as they appear in the index, or by purchasing a representative sample of the index components. Samples are often used if the index includes too many underlying assets or those assets are difficult to obtain.

While the vast majority of ETFs track an index or benchmark, actively managed ETFs have emerged as an alternative choice for investors. With these types of ETFs, as with actively managed mutual funds, a manager chooses a mix of investments to meet a specific investment goal or pursue a particular strategy.

What are some potential advantages of ETFs?There are two major advantages to buying an ETF besides flexibility: They are relatively low-cost and tax-efficient.

ETFs tend to have lower expense ratios -- the annual fees that funds charge investors -- than traditional mutual funds and index mutual funds. The average U.S.-based ETF has an expense ratio of 0.44%, according to Morningstar. (That means the average ETF would cost $4.40 in annual fees for every $1,000 invested.)

In contrast, the average U.S.-based mutual fund has an expense ratio of 1.22%, while the average annual cost of a U.S.-based index mutual fund is 0.91%.

Keep in mind, though, that investors who buy and sell ETFs will likely have to pay brokerage commissions on top of the fees delineated by the fund's expense ratio.

At the same time, because of the way they are structured, ETFs generally reduce capital gains distributions to investors and can be more tax-efficient than mutual funds.

There are exceptions. Leveraged and inverse ETFs, commodity ETFs and other types like currency-hedged ETFs, can create tax liabilities.

It's also important to understand that while ETFs might reduce tax liabilities while an investor is holding shares, an investor will have to pay capital gains tax on any gain when he or she ultimately sells.

What are the potential risks associated with ETFs?Like any investment, ETFs can expose investors to any number of risks. For example, just like any stock, ETFs can decline in price.

Sometimes, an ETF may have wide bid-ask spreads depending on a product's trading volume and market liquidity. An ETF's market price may also diverge significantly from the underlying value of its portfolio, if, for example, there is a disruption in the share redemption or creation process. Investors should exercise caution in the type of order they use when trading ETFs.

In recent years, asset types and investment strategies previously only available to more sophisticated investors have been increasingly made available more broadly to investors through ETFs. In some cases, more complex ETFs have entered the market, creating confusion and potential issues for investors who don't fully understand how the products work and the risks involved. One example is the exposure to market volatility as an asset class.

One area that has seen a great deal of investor interest recently is ETFs and mutual funds tracking so-called "smart beta" indices. A smart beta index is essentially any index that is based on a measure other than weighting by market capitalization. (In market-weighted indices, the higher the market value of a company's shares, the greater its influence on the index.)

Products tracking smart beta indices can carry investment risksand returns that may be very different from investments that track more traditional market-cap-weighted indices.

Smart-beta strategies may be less diversified than other investment strategies. For instance, a smart-beta ETF might be more heavily weighted in a particular sector or geographical region, which would amplify an investor's losses in the event of trouble in that sector or region.

That's why it's important for investors to read an ETF's prospectus and talk to an investment professional to make sure they understand its strategy and the risks they might encounter.

What happened to ETFs on Aug. 24?On Aug. 24, the Dow dropped 1,089 points at the open, the largest intraday decline in Dow history. Market safeguards that were put in place by the SEC in the wake of the Flash Crash of 2010 helped limit market volatility.

Those measures, and other factors, made it difficult for market makers to determine the price of underlying stocks held by ETFs. That is believed to be one factor that caused a number of ETFs to fall sharply before bouncing back. Investors who sold those ETFs in the interim suffered losses.

Mutual fund investors, in turn, were less affected because mutual funds price only at the end of the day.

The bottom line for investorsETFs can provide diversification, flexibility and exposure to a wide array of markets, at a relatively low cost. But as is the case with any investment product, it pays to be informed and understand the risks of ETFs (and the exact type of exchange-traded product that you are considering) before you make any decision.

An Alert Investor is a smarter investor.

This article originally appeared on The Alert Investor.

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