Defining the Exchange-Traded Fund

Index funds in general are often called "passive investments," in that they are directly tied to a securities index and not given to extreme fluctuation in the market, thereby allowing a fund manager to make as few decisions as possible regarding portfolio transactions while saving on transaction costs. Indeed, often the only "management" necessary in dealing with index funds is an annual or biannual balancing. And turnover on securities is much lower in index funds than comparative actively managed funds.

The index fund was created as the result of Vanguard Group analysis indicating that 75% of existing mutual funds earned as much as or less than the Standard & Poor 500 stock market index. The Vanguard Group than put together the first index fund, an investment that brought returns based on the firms listed in the Standard & Poor's 500. Today, popular indices for fund investment opportunities include Dow Jones indices, Lehman Aggregate Bond Index, the MSCI EAFE, the Wilshire 5000 and the Nasdaq 100. Firms such as Dimensional Fund Advisors, Fidelity, Global Investors and (especially in exchange traded funds) Barclays Global Investors have joined the Vanguard Group in issuing index funds.

The exchange traded fund can be considered an updating of the index fund, as the ETF is also an open-ended collective investment, but with a few adjustments made thanks to modern exchange dynamics. Like mutual funds and index funds, ETFs must be registered as an investment company with the Securities and Exchange Commission before the institutional investor gets shares which be listed on national exchange and traded.

As in index funds, ETF investors are dealing with blocks of stocks in an attempt to regulate the stock market index; as of late, ETFs based in a market sector, a commodity and even the Euro itself have been created. Unlike mutual funds, individual shares within ETFs and index funds are not redeemable in part.

ETF investment schemes also provide tax-exemptive relief in the U.S. This allows their registration as mutual funds despite their status as not individually redeemable, it permits the trading of shares in kind, and share prices are pre-negotiated. This latter advantage refers to the intraday trading nature of ETFs. While index fund pricing is set once daily at the end of trading, movement in ETF pricing is intraday and trading is done during exchange hours.

Another distinguishing feature of the exchange traded fund is its lower expense ratio as compared with mutual funds. The ETF expense ratio almost never tops 1%, while rates of 0.1% are common; mutual funds, on the other hand, run at least 1.5%.