Exchange traded funds (“ETFs”) are securities which trade on an exchange and usually track a stock, bond, or commodity index. Unlike an open end mutual fund, whose price is calculated daily at market close, exchange traded funds trade throughout the day and their price is determined by supply and demand. Unlike a closed end mutual fund, whose market price frequently deviates from its net asset value due to supply and demand imbalances, ETFs are created and redeemed by certain market participants, resulting in additional liquidity and market prices which tend to more accurately reflect their net asset value.
Exchange traded funds tend to have lower expense ratios than mutual funds as they are usually passive and oftentimes track a stock index such as the S&P 500 (U.S. large cap equity), Russell 2000 (U.S. small cap equity), or EAFE (Europe, Asia, Far East equity). They can also track a bond index such as the Barclays Aggregate Bond Index, or a commodity such as gold, silver or oil. They thus provide a way for an investor to obtain exposure to an asset class in a low cost, passive manner.
Exchange traded funds are typically structured as corporations or investment trusts, and the investor is thus entitled to dividends and interest generated by the underlying assets of the funds. Similarly, the investor is entitled to proceeds from the sale of the underlying assets upon liquidation of the fund.
Equity exchange traded funds are usually more tax efficient than open end mutual funds. This is due to the fact that ETF shares are created and redeemed in a manner which allows the share holder to have a cost basis in the fund which closely tracks the cost basis of the underlying assets of the fund.