In a Nutshell: An ETF is a passively rather than actively managed bundle of securities chosen for their similar asset class characteristics and traded as a single security on an exchange.
Definition: Exchange-Traded Funds—or ETF’s—are funds that invest in existing indexes, such as the S&P 500, The French CAC, The German DAX etc. In fact, any asset class that has a published index around it and that is publicly traded/liquid can be made into an ETF. Everything from real estate to bonds can be bundled under an ETF structure. For example, there are ETF’s that mirror/invest in specific commodities like Gold (GLD) or Oil (USO), as well as ETF’s that mirror specific sectors by putting together a basket of sector specific stocks or bonds under a single ETF, such as a corporate bond ETF’s, junk bond ETF’s, large-cap stock ETF’s, small-cap stock ETF’s etc. In many ways, an ETF is similar to an index mutual fund. Unlike mutual funds, however, ETF’s can be bought and sold like stocks on exchanges like the NASDAQ or the NYSE. Mutual funds are not traded publically; instead, you invest in a mutual fund whose management team then actively invests your money into stocks or bonds for you. Furthermore, ETF fees are typically much lower than mutual funds.
Advantages: ETF’s are less expensive than mutual funds. You will, however, have toopen a brokerage account to buy or sell ETF’s.
Risks: There are almost 1.8T worth of ETF’s being traded today, of which $1T is run by BlackRock, a major Wall Street Juggernaught. (Vanguard and State Street are the other big players in this space.) Some ETF’s are known as “levered” which means they use leverage to boost returns—this can also boost the losses if the particular ETF is in a sector or asset class that does poorly. Inverse ETF’s, which are ways to short (or bet against) a particular sector, index or asset class, can also involve leverage and are subject to heightened risk. Liquidity, however, is perhaps the greatest risk in the ETF space. Because these “baskets of other stocks” are effectively bought and sold on exchanges like single stocks, they are very much subject to the “slings and arrows of outrageous [market] fortune.” In other words: they can be sold off en mass in a market crash, dropping in value faster than the Titanic reached the ocean floor in 1912.
Further Reading: The performance of active managers (i.e. mutual fund managers) vs passively managed vehicles (i.e. ETF’s) is compared in Section 5 of “The Six Portfolio Secrets.”