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What are ETFs? The basics

Like mutual funds, exchange-traded funds (ETFs) are baskets of securities. Like stocks, ETFs trade on an exchange. Unlike regular mutual funds, ETFs can be bought and sold throughout the trading day. They can also be sold short and bought on margin. Anything you might do with a stock, you can do with an ETF.

What kinds of ETFs are out there?

There are a number of different equity ETFs on the market, including SPDRs, Select Sector SPDRs, MidCap SPDRs, and DIAMONDS. ETFs have also branched out into the bond arena with scores of bond ETFs now on the market. ETFs also come in more-exotic flavors. While conventional mutual funds still vastly outnumber ETFs; funds that drill down into specific sectors, industries, regions, countries, and asset classes make up a greater percentage of the ETF universe, offering relatively inexpensive access to investments such as currencies, precious metals or emergent industries that heretofore have been the sole province of larger institutional and wealthy investors.

About management

ETFs are largely passively managed, which means that each tracks a sector-specific, country-specific, broad-market, or other index. A manager isn't actively choosing which stocks to buy and sell.

Why indexing?

Why has indexing been the strategy of choice for ETFs? ETFs rely on an arbitrage mechanism to keep the prices at which they trade roughly in line with the net asset values of their underlying portfolios. For the mechanism to work, potential arbitragers need to have full, timely knowledge of a fund's holdings. So, many ETFs have chosen the indexed route because active managers rarely disclose their portfolio holdings more frequently than the Securities and Exchange Commission requires (which currently is four times a year).

Although ETFs are largely index-based, more actively managed or enhanced-index ETFs are gaining visibility. For example, the WisdomTree ETFs follow indexes that are weighted based upon stock dividend metrics rather than a more-traditional market-cap weighting. WisdomTree's research shows that a dividend weighting has provided stronger returns in the past, but the jury's still out on future performance.

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Actively managed ETFs on the horizon?

In addition, actively managed ETFs are a new innovation, but they still have much to prove to regulators, money managers, and investors about their portfolio transparency, fee structures, and real-world operations before they'd become widely available.

Dive Deeper: Exchange-traded funds: Everything you need to know about ETFs

This content was created in partnership with the Financial Fitness Group, a leading e-learning provider of FINRA compliant financial wellness solutions that help improve financial literacy.

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