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Exchange-Traded Funds (ETFs): Now Individuals Can Invest Like the Big Players

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This chapter describes the ways in which exchange-traded funds (ETFs) possess characteristics of both traditional open-end mutual funds and shares in individual companies.
This chapter is from the book

Exchange-traded funds (ETFs) are one of the fastest-growing investments in the United States. Their rapid growth is all the more remarkable because, unlike mutual funds, ETFs do not pay sales loads to financial intermediaries. Advisors who recommend ETFs rarely have financial incentive to do so.

ETFs are a powerful investment tool. However, before you use them, you should understand how they work and what makes them different from other mutual funds. This chapter introduces you to ETFs but only begins to discuss why you should use them. Chapter 2, “The Multifaceted Stock Market,” completes the presentation of the background necessary for you to fully appreciate the evidence in Chapter 3, “A One-Step Strategy for Selecting Superior Investments: Indexing,” showing that ETFs have outperformed and are likely to continue to outperform a majority of comparable mutual funds.1

ETFs Are a Special Type of Mutual Fund

ETFs hold a basket of individual stocks, just as mutual funds do. Each ETF share represents a proportional piece of the portfolio of stocks, as with mutual funds. Therefore, many of the advantages of mutual funds also characterize ETFs:

  • Ability to diversify with a single investment
  • Ability to gain exposure to a particular investment style (small versus large company stocks, for example) or to a specific industry (utilities, technology, etc.) with a single investment, without having to select individual companies

Saving the effort needed to select individual stocks can be helpful because the selection of individual stocks has been a less important determinant of investment performance than the selection of particular industries. For example, the steep rise in oil prices that started in 2003 has lifted shares in a wide variety of energy companies. During the same period, U.S. automotive stocks have faced great difficulties. As a result, even relatively uninformed energy investors are far more likely to have nice gains to show for the 2003–2006 period because any stock they picked is likely to have done well. On the other hand, even the most astute automotive analyst would have had a rough time making money by holding stocks in that sector. This is not to say that competition between two companies has never resulted in gains for one stock and losses for the other. Rather, industry-wide developments that move stocks across an entire sector have had a larger impact on the stock market than have company-specific events. (Even a takeover bid for a particular company often leads other companies in that sector to move.)

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