An Exchange Traded Fund (ETF) is very similar to a mutual fund and has the same basic idea. If a group of investors pool their capital and allow a professional to manage the account, they can achieve better results than if they each invested individually.
Similar to the mutual fund, an ETF is a security that an investor can purchase. The ETF is made up of underlying securities, such as stocks and bonds. ETFs will generally focus on a region or market sector. Thus, you could purchase an ETF focused on the Chinese market or the metals sector.
While ETFs and mutual funds are similar, the ETF has its own set of advantages and disadvantages.
Lower Fees - ETFs are usually passively managed which reduces management fees and other expenses.
Increased Liquidity - Just like a stock, you can buy or sell an ETF any time throughout the trading day. This makes it much easier to get in and out of a trade, as opposed to a mutual fund which only settles at the end of the day.
Better Tax Treatment - You, the investor, get to decide when you want to buy or sell an ETF and it is only when you buy or sell that taxes come into play. While ETFs do trade securities like a mutual fund, they do not receive a tax charge.
No Minimum Purchase Requirement - With an ETF, you can buy 1 share or 1,000 shares as there are no minimum purchase requirements.
Potentially Limited Options - Depending on the market in which you want to invest, you may be limited to selecting an ETF that only invests in large companies. While this may work for some investors, it does risk missing out on the opportunity for larger profits.
Trading Fees - ETFs, just like any other security, will require you to pay a broker commission when you buy and sell shares. In addition to any trading fees, ETFs are subject to a management fee called the expense ratio.
Leverage - Some ETFs do utilize financial leverage and you need to conduct thorough research into these before deciding to buy. Leverage involves borrowing money, using debt, to buy additional assets. If the trade is successful gains can be amplified, but losses can also be exaggerated should the trade not work.
Exchange Traded Funds can provide a good alternative to mutual funds for some investors and can be an important part of your portfolio. As with any security, the important part is doing your research before making a trade.