Similar to index mutual funds, ETFs are baskets of
securities that include stocks, bonds and other instruments attempting to
mirror a specific market index. Relatively new to the investment scene compared
to mutual funds, the first ETF surfaced in 1993 to emulate the S&P 500. By
contrast, the first mutual fund appeared in 1924 – a full generation prior.

ETFs trade in the same way stocks are bought and sold – on
major national exchanges at any time during the trading day. An ETF’s
underlying net asset value, or NAV, is determined by taking the current value
of its net assets (e.g. the basket of securities) and dividing this by the
number of shares outstanding.

The NAV of any ETF is published every 15 seconds. This, in
essence, should be equal or close to its actual market price, and this holds
true for most large, stable and established ETFs. However, the gap between NAV
and the actual market price may be wider and more volatile for ETFs holding
more exotic and fewer liquid assets.

ETF Advantages

1. Transparency: Investors benefit from the fact that ETF holdings and overall value are fully transparent. Once an ETF’s mirrored index is established, there’s little else to do in terms of asset management. Unless the index holdings change, ETFs are passively managed.
2. Cost: Because an ETF is passively managed, operating cost is extremely low compared to that of a typical mutual fund. As a result, minimal operating costs are passed on to the investor. Low fees are, in most cases, also below those for index mutual funds.
3. Tax-Efficiency: Since ETFs are passively managed, fund managers are not actively trading securities during the year as they would with mutual funds. As a result, ETFs are more tax-efficient. At the fund level, mutual funds generate realized gains and losses, whereby ETFs generate unrealized gains and losses.
4. Diversification within Sectors: ETFs enable investments in specific market sectors such as US Biotech or US Financial companies. A sector ETF may hold a basket of securities representing more than 90 percent of the entire sector. This provides broad-reaching exposure to the complete sector as well as diversification within the sector through exposure to most companies within an industry. A Sector ETF is ideal for investors who are bullish about the future of the pharmaceutical industry, for instance, but not willing to invest in individual stocks of several companies within that industry.
5. Risk Control and Liquidity: Not a proponent of active trading, I believe in a long-term passive investing approach through asset class diversification. However if you prefer active trading, particularly in a down market, it is possible to sell out of the market during the day more quickly and at a specified price. It’s also possible to take a short position on the market, sector or index using leveraged or reverse ETFs. Taking a short position means you’re betting the market will drop.

ETF Disadvantages

1. Broker Fees: As mentioned earlier, ETF fees at the fund level are extremely low when compared to mutual funds. But investors pay no sales charge or fees when purchasing most no-load mutual funds. Because ETFs are traded like individual stocks, they’re purchased through a broker and, as a result, assessed a commission. But discount brokers like Charles Schwab or Scottrade require as little as $9 per trade. ETFs work well for large lump sum purchases held for the long term. Active traders or proponents of dollar cost averaging (periodic investments over a long period of time) may not benefit from ETFs, as commissions can deplete profits or reduce an ETFs low cost advantage.
2. Complex ETFs: In the past few years, financial gurus have introduced many new complex ETFs that are considered speculative and, of which, investors should steer clear. ETFs mentioned earlier, such as reverse or leveraged, fall into this category. These hold derivatives and complicated asset holdings, which are less transparent to the average investor. Other examples of complex ETFs include those investing in commodities, precious metals and specific exotic market niches such as oil or companies located in third-world countries. An ETF should have at least $50 million in net assets, and those failing to attract enough investors could close down. Complex ETFs are also considered less liquid and harder to value. Consequently there may be a wider gap between NAV and price per share.

For most investors, the best ETFs invest in specific and widely tracked indexes. Indexes that track major asset classes paired with a long and stable history are ideal. Consult your financial advisor before making any investment decision.