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What is an ETF? An ETF, short for "exchange-traded fund," is a mutual-fund-like basket of investments that trades like a stock. They first launched in the United States in 1993. Though a few ETFs are actively managed, most simply track some sort of index.

Why not just get a mutual fund? You can only buy or sell shares of a mutual fund once a day, after the markets close. The fund needs to know the closing price for all its holdings before it can figure out what any given slice of those holdings is worth. In contrast, you can buy or sell shares of an ETF whenever you like.

What's the big advantage to ETFs? ETFs have five main benefits:

  • When it comes to management fees, many ETFs cost less than corresponding mutual funds.
  • Because they trade like stocks, ETFs also give investors greater flexibility. You can short an ETF if you want to bet that its price will fall, or place a limit order to buy or sell shares when they reach a certain price.
  • Unlike mutual funds, ETFs have no minimum investment requirements. You can buy as little as a single share or as many more shares as you like, whenever you like.
  • In addition, the way ETFs are set up generally leads to lower tax bills for their investors, compared to mutual funds.
  • Finally, ETFs cover a diverse array of different investments, from broad-market stock and bond indexes to funds tied to specific regions, countries, sectors, or commodities. If you've got enough know-how, ETFs give you a convenient way to invest in targeted slices of the market.

What's the catch? The key words in that previous sentence? If you've got enough know-how. Unless you're seriously plugged into the right corners of the market, investing in those specific nooks and crannies of Wall Street could end very, very badly for you. Most investors interested in ETFs should stick with the broader indexes, which offer less volatility and far fewer unwelcome surprises.

In some cases, ETFs can also ding you for commission fees every time you buy or sell them, just like stocks do. Shares of mutual funds, in contrast, often carry no commission, especially if you buy them directly from the fund company. However, an increasing number of brokerages are beginning to sell ETFs directly to customers with no commission fee.

Where can I learn more? Ready to take the plunge into ETFs? Consult the Fool's ETF Center for more information and advice.

At a recent house party, Fool online editor Nathan Alderman found himself giving a front-porch seminar on ETFs to curious onlookers. It was a pretty weird moment, honestly. The Fool's disclosure policy spiked the punch.

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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On June 19, 2010, at 10:41 PM, walkerlm wrote:

    'Tis a succinct summary of your front-porch seminar. I feel privileged to have been there at the inception.

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