The Exchange Traded Fund (ETF)

The exchange traded fund or ETF is a unique investment vehicle that has grown significantly in popularity in recent years. The ETF shares some common features with a mutual fund and an index fund. However, it has enough unique features to make up its own investment type. Since it is a relatively new type of investment compared to other investment vehicles, many people are still unfamiliar with it. Here are the basics of an ETF and how they work.

Background of the ETF

The preliminary ETF was first seen in the year 1989 on the American Stock Exchange. A company called Index Participation Shares came up with the idea and tried to get it started. However, the Chicago Mercantile Exchange filed a lawsuit to stop the sale of these products and won. 

One year later, Toronto Index Participation Shares started to sell a very similar product in Canada. These funds tracked the Toronto Stock Exchange 35 and 100 as an index. These ETF's proved to be very popular in Canada and as a result, the New York Stock Exchange wanted to develop a similar product that would suit the SEC. 

Out of this desire came the birth of the first legitimate ETF in the United States in 1993. An executive with the exchange, Nathan Most came up with Standard & Poor's Depositary Receipts. They later became known as Spiders or SPDR's and quickly became the largest ETF in the world.

Five years later, they came out with ETFs that were specific to certain sectors. Therefore, instead of simply tracking an index, you could track a certain sector if you wanted. For example, you could now track the oil or gold industry with your ETFs if you desired. Since then, ETFs have grown rapidly. There are now over 680 ETFs in the United States with over $600 billion in assets.

How They Work

As far as comparing an ETF to another type of investment, they are closest to a mutual fund. A share in an ETF is actually owning part of a portfolio of several other stocks within an industry or sector. However, the key way that they differ from mutual funds is that they can easily be traded on a stock exchange. With mutual funds, you can only trade them at the end of the trading day. With an ETF, you can trade them any time the exchange is open. They can be bought and sold just like stocks. In fact, you can even take an option out on an ETF. Therefore, the flexibility is unparalleled in the industry. 

With an ETF, you will usually pay a lower cost than you would with another similar type of investment. These funds are not actively managed like some mutual funds are. This passive form of management also results in lower capital gains because they are not buying and selling the stocks that make up the ETF. This will lower the capital gains tax burden that comes with other investments. 

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