An exchange traded fund, abbreviated ETF, is a fund that trades like a stock, and tracks an index, an asset class, a commodity, or basket of commodities. Like a stock, an exchange traded fund will transact throughout the day, and does not necessarily trade at it’s intrinsic value, or net asset value (NAV). This is unlike a mutual fund, which only trades on market close exactly at the net asset value.
Unlike a mutual fund an ETF is not actively managed, meaning its performance is meant to mimic the underlying asset(s) tracked as closely as possible, either on an intra-day or long term period, depending on the ETF. Exchange traded funds typically have much lower expense charges than mutual funds, making them attractive to some investors. ETFs are also attractive to day traders, who can trade an index or commodity with an equities trading account, rather than a futures or commodities account.
Some exchange traded funds are meant to trade double or even triple the volatility of the underlying index or asset tracked. These funds are solely for the purpose of day trading, and never should be held long term as they have considerable decay in their net asset value. The reason for the decay is the use of leveraged products to create the extra volatility. Recently these funds have come under more regulatory scrutiny because by design, they will all eventually be worth $0. They also create extra volatility in the market as a whole as the funds must rebalance their own assets during the trading day.
While an exchange traded fund is not necessarily required to trade at a share value which would correspond exactly with the true NAV, any significant deviate would qualify as an arbitrage opportunity, and any inefficiencies in pricing are typically rooted out very quickly by high frequency traders.
ETF volume accounts for hundreds of millions of shares of market volume daily, and these products have become very popular amongst both investors and traders. The most popular ETFs include: SPY (S&P 500), EEM (emerging markets), GDX (gold miners), VXX (S&P 500 VIX), and XLF (Financials).
Sometimes an ETF may be useful to a trader acting on sector specific news, when the trader is unsure how one particular asset within the sector will be affected. An example is when the US Government decided to increase capital holding requirements of banking institutions. Without a full analysis of each bank, a trader would not know how significantly each would be affected. Instead knowing that the industry as a whole would likely decline in price on the news, the trader may have decided to short the XLF (Financial Sector)
Traders and investors alike should educate themselves on exchange traded funds as they provide a useful alternative to other assets.