An ETF (exchange traded fund) is an investment fund that trades just like any other stock in the market, in that you are buying your shares from another investor instead of the fund manager.  An ETF can hold virtually any asset including but not limited to stocks and bonds and is usually an index fund (although that is changing).  Its growing popularity is due to its low cost, tax efficient structure and ease of purchase.  You just need a normal brokerage account.   Whether you want to target a specific sector or index, there is an ETF for any situation.

Broader the Better. When you are starting a portfolio, an ETF can be an excellent way to target a wider range of the market.

• Options. There are many ETF’s where some only track 30 or so stocks whereas some track the major indexes.  Also, you can find one for just about anything you could want to get into.
• Volatility. the S&P 500 index ETF (SPY) is great because it tracks many quality stocks does not have violent swings in price that more specific funds would have.  On the other hand, the Market Vectors Agribusiness index ETF (MOO) is based on a lot of agriculture stocks such as Monsanto and DuPont.  If one of the companies gets hit with bad news it will hurt the whole fund since the companies are all related.  This shows that it is generally much safer to buy a broader index fund.

3 pieces of key information and 1 myth. When choosing an ETF, looking at assets, tracking error and expenses is a must but is volume really all that important?

• Volume. A common misconception with ETF’s is that the more they active it is, the more fairly it’s priced.  In fact, it doesn’t matter how many shares are traded.  Three times every day, the funds management sends the current asset value to the market makers who keep the price accurate and up to date.
• Assets. Another good idea is to keep an eye on the amount of assets held by the ETF.  A general rule of thumb is 100million which means there is a decent amount of interest in the fund.  Low amounts of net assets can be a red flag which shows lack of confidence in the fund.
• Tracking Error. To gauge how well an ETF follows its underlying assets you can check the tracking error.  For the S&P 500(SPY) it is currently .06% which means it almost perfectly follows the index.
• Expenses. Checking on the ETF’s expense ratio can get a sense of how much it costs them to manage the fund.  There are usually different ETF’s that track the same index so looking at particulars such as this is a good way to separate good from bad.

Overall, ETF’s can be a useful addition to any investment strategy.  If relative safety, liquidity, price and numerous options are important criteria for your investment strategy, then it would be smart to put ETF’s on your radar.