An Exchange Traded Fund (ETF) is a Mutual Fund whose shares trade on an exchange, such as the New York Stock Exchange (NYSE). These shares trade every day, all day that the exchanges are open, just like a stock. Normal Mutual funds only trade once a day, at the end of the day, at a set price the NAV or Net Asset Value. The NAV is determined by the price of the stocks or bonds that the fund owns multiplied by the number of shares that the fund owns divided by the total number of fund shares. ETF’s are priced by the market. In theory, the price of the ETF should be the value of the shares that the ETF owns. However, in practice, the price can vary, thereby producing a premium or a discount. A premium occurs when the investor could purchase the same companies for less than buying the ETF, and a discount occurs when the investor can buy the ETF for less than the price of the shares.

ETF’s can be much more tax efficient than a normal mutual fund, for the individual investor. The investor gets to determine when she sells the shares and realizes gains or losses.

ETF’s usually carry much smaller fees than normal mutual funds. This will result in a larger gain in the long run for investors in ETF’s. If one were to invest in two mutual funds that represent the S&P 500, one a normal mutual fund with management fees of 1% and on an ETF with fees of 0.5%, the ETF will out perform the normal mutual fund by 0.5% per year. This adds up over time.

Cons: Trading costs, commissions are charged by your broker every time you make a purchase or sale. The individual investor needs to be aware of this.

In my opinion, ETF’s are the way to invest for the individual investor. At this time only a few ETF’s are actively managed. This means that almost all ETF’s are passive investments, and the individual investor needs to only pick a benchmark that he wants and then pick an ETF. Verify that the fees charged by the ETF are comparable to al the other ETF’s that match that benchmark.

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