What is an ETF? That's a great question to know the answer to, because many of us would do well to consider investing in ETFs -- certain ones, at least.
What is an ETF?
An ETF is an exchange-traded fund. I often describe ETFs as a cross between mutual funds and stocks. That is accurate, but let's dig a little deeper.
Exchange-traded funds are relatively new, having appeared on the scene in the early 1990s. They've grown in popularity considerably in that time: As of the end of 2014, about $2 trillion was invested in these funds, up from $1.7 trillion the year before. They're growing in number, too, from 1,294 to 1,411 in 2014. (They're still second fiddle to mutual funds, which held nearly $16 trillion at the end of last year, across about 7,900 funds.)
They're like mutual funds in that they offer investors shares of a pooled investment in a variety of stocks, bonds, or other assets. Most ETFs are registered as investment companies and are regulated by the Securities and Exchange Commission, as are mutual funds. There are other distinguishing characteristics about ETFs, such as how they're created, but they have little bearing on how you'll use them.
Many ETFs are designed to track various indexes, like index mutual funds. They'll hold the same securities as the index and will aim to deliver roughly the same performance.
Why are ETFs good -- or bad?
Exchange-traded funds offer a handful of advantages over both stocks and mutual funds. A stock is an investment in just one company, but the ETF, while working much like a stock, offers easy diversification across a number of securities with each share. Mutual funds offer that kind of diversification, but you essentially can only trade in or out of them once daily, and their price (their "net asset value," or NAV) is generally calculated once a day, too. ETFs, like stocks, let you get in or out at any time during the trading day, with their value updated throughout. That's not necessarily the most valuable aspect of ETFs, though, as rushing in or out of holdings and trading frequently isn't the best road to riches. The fact that ETFs make it easy to do so is a knock against them, in some people's eyes.
Another advantage over mutual funds is that ETFs tend to have lower annual fees ("expense ratios"). They also offer a tax advantage, because you choose when you want to sell them, letting you time when to realize gains. While many mutual funds have minimum investment requirements, such as $500 or $3,000, you can always buy just one share of an ETF, or as many as you want or can afford -- though your brokerage will likely charge you its standard commission for doing so. (Thus, buying a $60 share and paying a $10 fee is suboptimal, as such a high percentage of your investment is going toward the trade. Still, it's possible.)
You can also short ETFs (i.e., bet against them, expecting them to fall in value), which you can't do with mutual funds. That's something only more experienced investors should consider. There are also "inverse" ETFs that are constructed as bets against certain securities or indexes -- but they can be rather risky over short periods and very risky over long periods. This is another knock against ETFs -- they have made some risky ways to invest rather easy.
Which ETFs make the best investments?
There are gobs of ETFs out there that represent all kinds of broad markets and niches. There are ETFs tracking major indexes such as those covering the S&P 500, the entire world stock market, mid-cap stocks, small-cap stocks, emerging markets, and so on. There are also ETFs focused just on aviation companies, environmentally friendly companies, Indian stocks, high-yielding stocks, mortgage finance companies, healthcare companies, commodities such as gold, low-volatility stocks, and so on.
In general, many, if not most, investors would be well served by just a few inexpensive broad-market ETFs, such as the SPDR S&P 500 ETF (NYSEMKT:SPY), Vanguard Total Stock Market ETF (NYSEMKT:VTI), and Vanguard Total World Stock ETF (NYSEMKT:VT). Respectively, these three invest you in the largest 80% of the U.S. stock market, the entire U.S. market, or just about all of the world's market.
But other ETFs could make sense for you as well. For example, if you have great faith the biotech industry will perform well over time, but you don't know which companies are best for your portfolio, you might opt for a biotech ETF that will give you stakes in a few dozen biotech companies. Same goes with many other industries or regions.
Take some time to learn more about ETFs, and see whether they make sense for your portfolio.
Longtime Fool specialist Selena Maranjian, whom you can follow on Twitter, has no position in any stocks mentioned. Selena is glad she read this article, because she used to think an ETF was an enhanced trampoline filter. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.