An ETF Primer

For those of you who stay up to date on the financial markets I'm sure you have watched with wonder as ETF's have gone from obscure investment product to a position of relative prominence in the industry. For those of you not in the know perhaps a quick brush-up is in order.

An ETF, or an Exchange Traded Fund, has the following features:

1. ETF's are listed on an exchange and thus trade like a stock (High Liquidity)
   
2. When you buy one ETF you get access to a basket of securities (Diversification)
3. An ETF typically tracks an index or an intellidex, and as such it is not actively managed (well at least not yet . . .).
4. ETF's are tax efficient and have very low fees.

While this is by no means an exhaustive list of the traits of ETF's it should be enough for many of you to realize how advantageous these instruments can be for the average investor. In fact many of the top pro's (like Yale's David Swenson) in the industry are now recommending ETF portfolios to the average investor.

For years mutual funds were the standard way to get diversification in a portfolio. When you buy a mutual fund you pay a front end load to get in and then an annual management fee around every single year. The idea is you pay a smart money manager to manage your investments, benefit from being diversified and hopefully get better returns as a result.

One problem; mutual fund returns after expenses underperform the market. In all my reading I have yet to find an economics article in a peer-reviewed journal that has been able to convince me that mutual fund managers are able to "Add Alpha."

The solution: if you can lower your fees, create more tax efficiency and access markets that were previously inaccessible to the average investor, and do all of this using ETF's, it seems like a no-brainer. Unfortunately that isn't the end of the story.

ETF's have trading costs and can suffer from tracking error. They are not great for every investor. They are perhaps best for lump sum investors with a buy and hold philosophy rather than for those making systematic contributions or who actively trade.

I suggest you brush up on the basics using the following resources and we'll pick this up again next week. Feel free to fire off any comments/questions.

• Read the good news about taxes and the balanced view on taxes.

• Read about how well ETF's do at tracking their indexes.

• Read about how ETFs give access to new markets.