A Beginner's Guide to Exchange Traded Funds (ETF's)

ETF's, or Exchange Traded Funds, have grown in popularity over the last decade. Many individual investors have heard of some of the popular ETF's such as Power Shares, Pro Shares and iShares, but they do not understand how they work. This article will give a quick overview of what ETF's are, how they are traded and what types of ETF's are available.

Exchange Traded Funds can be thought of baskets of securities, usually stocks, which an individual investor can buy and sell. For example, the Standard and Poor's 500 ETF contains all of the stocks that are in the Standard and Poor's 500 Index. As a result, when you buy the S&P 500 ETF you are actually buying stock in each and every company in the S&P 500 Index.

ETF's trade on the major stock exchanges such as the New York Stock Exchange and NASDAQ in the same manner as individual stocks. Each ETF has its own symbol on the stock exchange that it is listed. For example, the Standard and Poor's 500 ETF which is mentioned above has the symbol SPY. The price of ETF is determined by the prices of the stocks held within the ETF and the price of the ETF will rise and fall in conjunction with the prices of the individual stocks throughout the day. Unlike mutual funds which can only be purchased or sold at the end of the day, investors can buy an ETF anytime throughout the day.

ETF's are available in an amazing variety. There are ETF's based on market capitalization (large cap, medium cap, small cap). There are also sector based ETF's. For example, there are ETF's whose underlying stocks are concentrated in the energy sector. Others specialize in technology, healthcare or banking. You can also find ETF's that invest in companies of particular countries such as China, India or Russia.

There are also ETF's available that short, or bet against, the underlying stocks that they own. In theory, the investor that buys one of these short ETF's is hoping that the stocks within the ETF actually go down in price. When the stock prices fall the price of the ETF will increase. Many people use these short ETF's when they believe that the stock market is overpriced and they want to make a profit when the market corrects, or goes down. Others use these short ETF's as a way to hedge or protect their stock portfolio in case the market declines.

A fairly new group of ETF's offers double or even triple exposure to the underlying stocks within the ETF. For example, the ProShares Ultra S&P 500 (symbol SSO) will increase in price at a rate of double that of the S&P 500. So, if the S&P 500 increases by 5%, the ETF will increase by 10%. This sounds great, but be reminded that the opposite holds true also: if the S&P 500 decreases by 5% then the value of the ETF will be reduced by 10%. These "ETF's on steroids" are available from many ETF providers in a wide variety of styles.

ETF's are a powerful tool for individual investors. They can be used to complement a portfolio of stocks or they can be stand alone investments. ETF's also offer a great way to hedge a portfolio. If you have not done so already, look into incorporating ETF's into your investment strategy and speak with your financial advisor to see if ETF's make sense for you.