Exchange Traded Funds (ETF)

Before I get into ETF's, and how they differ from traditional Mutual Funds, I need to explain how mutual funds work. First of all, there are two basic types of mutual funds: open ended and closed ended. Normally, when mutual funds are discussed, we are talking about open-ended funds. These are funds that hold stocks, bonds, or whatever and the investments in the fund can change based on the decisions of the manager. He may find new investments that he adds to the fund at any time. "Open-ended" refers to the flexibility of the investment portfolio to change. On the other hand, a Closed-Ended fund starts life with a basket of stocks and keeps them for the life of the fund. I will discuss the Closed-End fund in my next post. Both of these types of funds are priced at Net Asset Value (NAV). Net Asset Value is calculated by multiplying the number of shares times the closing price of those shares and added up, then divided by the number of mutual fund shares outstanding. That's a lot of math. Imagine the fund has 600 stocks, there is no way that NAV could be calculated and published throughout the trading day. This is why the NAV is only calculated at the end of  the trading day. So how does that affect you? Well, if you owned an open-end fund and had a nice gain in it and one morning you turned on the T.V. and saw that the stock market was falling dramatically, you would want to sell your fund to preserve your profits, right? Too bad, you can't. You have to wait until the market closes before your order to sell gets executed. However, if you owned an ETF, it can be sold during the trading day. It trades like one single stock. The mechanics of an ETF are complex but the end result is that it gives you trading flexibility, low fees, tax advantages and transparency. There are now over 1500 ETF's  currently traded and they cover almost every asset class,ie, stocks, bonds, commodities realestate, etc. I use ETF's to make sector bets based on my forecasts. For example, if I think that defense stocks will outperform the market, I will buy an ETF  that holds defense related stocks. This one trade provides me with diversification in the sector with low fees.In my next post I am going to talk about Closed-End mutual funds which are the unloved cousins of ETF's.