An Exchange Traded Fund, or ETF, is a type of investment fund that is being traded like a stock in a stock exchange. It functions like an index fund in that it tracks a certain index, a type of commodity or a selection of different assets.

But ETF’s differ in that they are being traded like stocks that also go through several price changes during the course of the day as they are being bought and sold.

Basics

An exchange traded fund allows investors an opportunity to invest in a wide range of securities much like a traditional mutual fund.

An exchange traded fund can be comprised of different types of securities pooled together as a single unit and offered to investors similar to shares of stocks. But unlike a traditional mutual fund, ETF’s can be bought or sold on a daily basis through a securities exchange just like stocks.

ETF’s are not sold or redeemed as individual shares at their net asset value. Instead, ETF shares are bought and redeemed in large blocks called creation units. Creation units purchased or redeemed are usually in kind.

It can either be a collection of securities that may be of the same type and proportion as that held by the ETF. There are also such funds that may permit or allow a buying or redeeming shareholder to substitute cash for some or the entire basket of assets included in the ETF.

Benefits

ETF’s are investments that offer lower expenses in terms of costs spent in trying to own one. The expense ratio for traditional mutual funds usually average about 1.5 percent while ETF’s range about 0.13 percent. This can save the investor a substantial amount that can be added into the investment portfolio rather than being included in the expense column.

ETF’s also offer the advantage of diversification that mutual funds offer and the flexibility of a stock share. ETF’s are available for investors who wish to create a more diversified portfolio to take advantage of growth in a variety of markets. And with ETF’s is being traded like stock shares, investors can take advantage of short term price changes enjoyed by a certain index during the day.

ETF’s also attractive in that they offer a more efficient tax structure. Between mutual funds and ETF’s belonging to the same asset classes, ETF’s are seen to be more tax efficient. There are many instances that taxes on ETF’s can be deferred until the shares have been sold or redeemed.

A simple instance would be when certain ETF shares are being redeemed "in kind". This way ETF’s traded in large volumes can be redeemed for shares of other stocks that belong to the index that ETF’s track. This way, tax implications of such trades are minimized.