What Are Exchange-Traded Funds?

Like mutual funds, exchange-traded funds (ETFs) are baskets of securities. Like stocks, ETFs trade on an exchange. Unlike mutual funds, ETFs can be bought and sold throughout the trading day. They can also be sold short and bought on margin. Anything you might do with a stock, you can do with an ETF.

What kinds of ETFs are out there?

There are a number of different equity ETFs on the market, from a number of different sponsors. Bond ETFs have also become more common. ETFs also come in more exotic flavors. While conventional mutual funds still vastly outnumber ETFs, funds that drill down into specific sectors, industries, regions, countries and asset classes make up a greater percentage of the ETF universe, offering relatively inexpensive access to investments such as currencies, precious metals or emergent industries.

About management

Most ETFs are passively managed, which means that each tracks a sector-specific, country-specific, broad-market or other index. A manager isn’t actively choosing which stocks to buy and sell in an attempt to beat an index.

Why indexing?

Why does indexing work well with ETFs? ETFs rely on an arbitrage mechanism to keep the prices at which they trade roughly in line with the net asset values of their underlying portfolios. For the mechanism to work, potential arbitragers need to have full, timely knowledge of a fund’s holdings. Indexing thus pairs well with ETFs because the contents of ETFs and the indices they track are public, as opposed to the contents of most actively managed mutual funds, which rarely disclose their portfolio holdings more frequently than what the Securities and Exchange Commission requires.

Although ETFs are largely index-based, more actively managed or enhanced-index ETFs are gaining visibility. For example, there are ETFs that follow indexes that are weighted based upon stock dividend metrics rather than a more traditional market-cap weighting.

Anything you might do with a stock, you can do with an ETF.
Most ETFs are passively managed.

Actively managed ETFs on the horizon?

In addition, actively managed ETFs are a newer innovation but comprise a small percentage of the overall assets invested in ETFs.