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An exchange-traded fund, or ETF, is a marketable security that tracks a certain index and trades on a major stock exchange. ETFs are available to invest in stocks, commodities, and bonds, and have some of the properties of mutual funds and some properties of common stock.

Similarities to mutual funds

Like a mutual fund, an ETF allows investors to spread their money around without relying too much on any individual stock or bond, or owning any commodities directly. For example, an S&P 500 ETF would own all 500 stocks that make up that index, and in the same proportions. For this reason, ETFs can be great for adding diversification and exposure to different asset classes to your portfolio.

In fact, many ETFs have corresponding mutual funds offered by the same companies. Using the S&P 500 example, the Vanguard S&P 500 Index Fund and the Vanguard S&P 500 ETF are the same product -- just in different forms to satisfy the preferences of different investors.

Just like mutual funds, an ETF has an expense ratio, meaning that a percentage of the fund's assets are used to cover management and other costs. ETFs often have lower expense ratios than similar mutual funds -- sticking with our example, the Vanguard S&P mutual fund has a gross expense ratio of 0.16%, while its ETF counterpart charges just 0.05%. However, you'll pay standard trading commissions when buying ETF shares, which could offset this benefit, at least somewhat.

Key differences and advantages of ETFs

Unlike a mutual fund, an ETF is traded on a major stock exchange, and the price you'll pay to buy shares is determined just like a common stock: by the instantaneous market value. Mutual funds calculate their net asset value and share price once per day, while ETF pricing is continuously changing.

Like other common stocks, it is possible to buy an ETF on margin, or sell shares of an ETF short. Many ETFs have options available. And, like common stocks, you'll typically pay your brokerage's standard commission when investing in an ETF, while this is not the case with mutual funds. Recently, some brokerages started offering a selection of commission-free ETFs, so check with your brokerage if you're interested.

Also, many mutual funds have minimum initial investment requirements, while ETFs have no such rules. The minimum investment you have to make in an ETF is simply the cost of one share. Many Vanguard mutual funds have minimum initial investment amounts of $3,000, while it's completely possible to start investing in a corresponding ETF with less than $100, especially if you find one that's commission-free.

Leveraged ETFs

No discussion of ETFs would be complete without mentioning (and warning you about) leveraged and inverse ETFs. A relatively new idea, some ETFs use leverage and/or derivative securities to amplify or reverse the fund's returns. An inverse ETF seeks to produce the opposite return of an index, while a leveraged ETF is intended to produce a multiple of the index's daily performance, usually two or three times.

Without getting into the mathematics behind them, you should know that leveraged ETFs are a bad idea as long-term investments. That is, they tend to go down over the long run, no matter what the underlying index is doing. These can be great tools for professional traders, but investors should generally leave these alone.

Should you choose an ETF or mutual fund?

If you prefer investments that trade easily and don't have a high minimum initial investment, ETFs can be a good choice for you.

One final word of caution: Because of the liquidity of ETFs, many investors are more tempted to trade in and out of ETF positions frequently. ETFs that track a stock or bond index are generally designed to be long-term investments, and it's important to treat them that way.

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