ETF or Exchange Traded Fund is an investment vehicle that tracks a commodity or an index but is traded like a stock on a securities exchange.

ETFs are securities that closely resemble index funds, and can be bought and sold just like a common stock. They offer the convenience of a stock with the diversification of a mutual fund.

The first ETF was the Standard and Poor’s Deposit Receipt (SPDR or Spider) launched in 1993.

Purchasing Spiders gave investors a way to mimic the performance of the S&P 500 without having to purchase an index fund. Furthermore, because they traded like a stock, SPDRs could be bought and sold throughout the day, purchased on margin, or even sold short.

Only, ETFs don't sell shares directly to investors. Instead, each ETF’s sponsor issues large blocks (often of 50,000 shares or more) that are known as creation units. These units are then bought by an authorised participant, typically a market maker, specialist or institutional investor, which obtains shares of the underlying securities and places them in a trust.

The authorised participant then splits these creation units into ETF shares each of which represents a legal claim to a tiny fraction of the asset in the creation unit and then sells them on a secondary market.

Advantages

ETFs have no front- or back-end loads. In addition, because they are not actively managed, most ETFs have minimal expense ratios, making them much more affordable. ETFs can be bought and sold at any time throughout the trading day.

In a traditional mutual fund, managers are typically forced to sell portfolio assets in order to meet redemptions, triggering capital gains taxes.

But the buying and selling of shares on the open market has no impact on an ETF’s tax liability, and those that choose to redeem their ETFs are paid in shares of stock rather than in cash. This minimises an ETF’s tax burden.

Minus factors

On the flip side, since the securities that an ETF tracks are largely fixed, investors who prefer active management will probably find ETFs wholly unsuitable.

Furthermore, because they trade as stocks, each ETF purchase is charged a brokerage commission.

For those who make regular periodic investments, such recurring commissions might quickly become cost-prohibitive.

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