Complete Guide to ETFs

When ETFs were first introduced, most only tracked the largest and broadest Indexes, but in recent years, they've grown in sophistication and popularity. Today you can buy ETFs that track just about any index or sector, and even some that try to emulate a strategy rather than following a specific group of investments.

An ETF (Exchange Traded Fund) trades on an exchange just like a stock, but rather than being a single security, ETFs hold a group of investments. They can be made up of bonds, precious metals, natural resources and many other asset types, ETFs are not limited to stocks. Don't let that flexibility fool you though, they are never a random hodge-podge of securities. An ETF always combines together a group of investments that have something in common and then tracks the combined performance. Most follow some type of Index, such as the S&P 500, and when you buy a share of an ETF, you get a small piece of every stock that the index tracks.

One thing that ETFs have in common with traditional mutual funds is that they pass their expenses on to you, the investor. There are two important tests that every ETF you buy should pass... First, minimize expenses by shopping for ETFs that have lower expense ratios than other ETFs tracking the same index. This is important because ETF expenses come right out of your returns. Second, make sure your ETF is accurately tracking its index, many can lag behind as a result of expenses or poor management. I'll explain how to perform both of these essential ETF tests below.

The major difference between ETFs and traditional mutual funds is that you can buy ETFs throughout the day the same way you would buy a stock. Traditional funds can only be bought at the end of the trading day and everyone receives the same price, whereas ETFs are subject to the same daily price fluctuations that a normal stock would experience. One impact of this difference is that, since ETFs trade just like stocks, you will be charged transaction fees, but we'll discuss expense management below.