NEW YORK (CNN/Money) - In the world of fund-type investments, exchange-traded funds are state of the art. ETFs offer investors an extremely cost-effective way to invest in broad categories of stocks and bonds with all the convenience of buying common shares.
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The history of mutual funds has been shaped by the need to accommodate shareholders who are constantly adding and withdrawing money. The original answer was the closed-end fund, which maintains a fixed number of shares.
Once technology advanced to the point that contributions and withdrawals could be processed every day, open-end mutual funds became the vehicle of choice. But these funds could only handle inflows and redemptions once a day.
By the 1990s, however, advancing technology made ETFs possible. ETFs trade on major exchanges. Investors can buy and sell shares virtually continuously throughout the trading day. And the value of ETF shares doesn't deviate from the value of the underlying securities, as is the case with closed-end funds.
Most ETFs are essentially index funds – with a single share providing a stake in the securities of the target index. There is a wide variety of market sectors investors can track, including blue chips, mid-size companies, growth stocks, value stocks, real estate investment trusts and bonds. Barclays Global Investors, the leading packager of ETFs, offers more than 80 "iShares."
There are enormous advantages to the structure of ETFs. Most have very low management fees -- as little as one-fifth of a percentage point a year. By contrast, actively managed open-end funds typically carry fees from three-quarters of a point to more than a full percentage point.
Because ETFs trade on stock exchanges, investors do have to pay brokerage commissions. But those commissions are relatively low if you use a discount broker and are investing more than $3,000 at a time.
The lower annual fees of an ETF, compared with those of an actively managed fund, will more than cover commissions if you hold for three or four years.
Of course, if you have a regular investing plan, contributing a small amount each month to an open-end fund, for example, would make more sense. Still, open-end index funds lack several of the advantages of ETFs.
Because ETFs trade like regular common stocks, you pretty much know the price when you buy or sell -- instead of discovering your price after the close, as you do with an open-end fund. This could be especially important, for instance, if you wanted to sell your fund shares immediately in a rapidly declining market.
In addition, because ETFs trade on exchanges, they offer all the features of a common stock -- you can see what price trends are, you can place limit orders, you can buy on margin, you can even sell ETFs short.
Buying an ETF that tracks an index like the S&P 500 gives you the benefit of very broad diversification, a level of volatility that is actually slightly lower than the average for managed equity funds, and minimizes your investing expenses. For investors who don't want to pick individual stocks but want to benefit from the long-term profits of equity investing, ETFs are an extraordinarily convenient and cost-effective vehicle.