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A security that represents all the stocks on a given exchange. For example, an exchange-traded fund may track the Standard and Poor's 500. The organization issuing the exchange-trade fund owns each of the stocks traded on the S&P 500 in approximate ratio to their market capitalization. ETF shares can be bought, sold, short-sold, traded on margin, and generally function as if they were stocks. Investors use exchange-traded funds as a way to easily diversify their portfolios at relatively low cost. See also: SPDR.
exchange-traded fund (ETF)
A mutual fund whose shares trade on a securities exchange, generally at or very near net asset value per share. Unlike ordinary mutual funds that continually issue and redeem their own shares, exchange-traded funds are similar to closed-end investment companies whose shares trade among investors. The share price is maintained at or near net asset value because of the ability of large investors to convert ETF shares to the underlying stocks or to trade underlying stocks for shares of the ETF. See also creation unit.
Case Study The exchange-traded fund has become a very popular investment, in large part because of the low expenses and great flexibility. Annual expense ratios for ETFs are often lower than even the lowest-cost index funds. ETFs can be used either to buy or short the overall market or a specific segment of the market. These funds can also be used to hedge an investment position. For example, an investor holding a diversified portfolio of stocks can hedge an expected market decline by shorting shares of an exchange-traded fund that replicates the S&P 500. Investors with more specialized portfolios have the option of using other ETFs that track a more focused index. The market price of an ETF efficiently tracks a stock index because large investors are permitted to swap ETF shares (generally, 50,000 shares) for the underlying stocks that compose the index, and vice versa. If an ETF market price moves below its net asset value, investors will swap the ETF shares for shares of stock composing the ETF portfolio. Conversely, if an ETF market price moves above its net asset value, investors will swap shares of stock that underlie the index tracked by the ETF for shares of the ETF. The swapability of ETF shares for shares that compose the index keeps the market price of the exchange-traded fund near its net asset value.