What Are ETFs?

The Facts

ETFs are are shares in a pool of assets that mirror a specific index. Indexes track the price changes of different groups of investments. Some well-known indexes are the Dow Jones Industrial Average and the S&P 500. A ETF holds securities to match the securities or changes in an index's value. ETFs trade on the major stock exchanges and are bought and sold just like shares of stock.

History

The first ETF in the United States was the SPDR S&P 500 with the market symbol SPY. SPY started trading in January 1993 to track the S&P 500 index. The SPDRs, pronounced "spiders," were expanded in 1998 with an ETF for each of the nine sectors within the S&P 500. Barclays soon launched the iShares group of ETFs based on the MSCI international and global stock market indexes. Soon ETFs were being developed to follow a wide range of indexes; by 2004 there were 150 ETFs available. By 2009, that number had grown to over 800.

Function

ETFs shares trade on the major U.S. stock exchanges. Retail investors buy and sell shares the same way they would for any stock. New units or shares are created when institutional investors deposit cash to the ETF management company for additional units. Typically, new units are created in blocks of 50,000 shares, which are then sold into the market exchanges. Because ETFs are exchange traded, their prices fluctuate during the day along with the tracked index. This fluctuation allows investors to buy and sell throughout the trading day. This trading versatility is a significant contrast to mutual funds, whose prices are set only once a day after the markets are closed.

Types

Besides stock market tracking ETFs, EFTs now cover a wide range of investment classes. Some of the popular funds track commodities, such as gold, silver, oil and natural gas. Others cover fixed-income products like government and corporate bonds. The stock market of individual countries such as Russia, China and Brazil have tracking ETFs. ETFs have also been developed to track smaller market sectors such as homebuilders and shipping stocks. A recent development is inverse ETFs, which move in the opposite direction of the target index.

Potential

ETFs allow investors and traders to work in a diverse range of investments with all of the tools of stock market trading. These tools include margin accounts, selling short, limit orders and options. Investors profit from inverse funds when an asset class loses value, without the restrictions of short selling. ETF trading volume is steadily becoming a larger percentage of all stock market volume as investors use them to invest with or against the overall market trends.