An Exchange Traded Fund (often referred to as an ETF) is an investment vehicle. It is traded in a similar way as stocks on the stock exchange markets. It’s value is affected by the change in the price of the asset to which it is associated. These assets may be stocks, commodities and bonds etc. and trades close to its net asset value throughout the trading day.

Exchange Traded Funds have become a preferred type of investment product to be traded due to their low cost and the tax benefits that are highly sought after by investors. Their ‘stock’ like features make them very popular. The benefit of these types of funds over normal stock is that they are open ended mutual funds and their value can vary intra-day as opposed to closed ended funds. Exchange traded funds provide high trading flexibility to the traders. Their low cost, transparency and full market participation are added advantages too.

How did Exchange Traded Funds come into existence?

These first funds originated in 1989 with index participation shares which were traded on the American Stock Exchange and the Philadelphia Stock Exchange. Soon after, their trading was stopped as the Chicago Mercantile Exchange was able to bring to an end their sales in the United States with a lawsuit. They started trading again after the lawsuit issues were sorted out and since then they have flourished and have built their way towards sustained growth representing a number of regions, sectors and commodities like bonds, futures and a number of other assets. As of September 2010 there were around 916 exchange traded funds in the entire United States of America. The number has attained a remarkable growth of 27% during the last 12 months and the total asset value increased from US$ 693 billion to US$ 882 billion in the same period.

The advantages of exchange traded funds

As previously mentioned, Exchange Traded Funds have become one of the most popular investment methods around the world in past few years. This is because of their easy diversification, low expenses associated and high tax efficiency provided to investors. Even after providing numerous such benefits, they maintain the features and ease of normal stocks which are traded over the stock exchange markets. They are lower in cost compared to other investment funds and provide high level of buying and selling flexibility (liquidity) to the investor. They can be traded at the instantaneous market price any time of the day as opposed the mutual funds which can be traded only at the end of the day. These funds are not required to sell securities to meet the investor’s underlying investment activity hence they provide a higher level of tax efficiency along with providing a higher degree of market exposure and diversification. This helps traders and investors to earn profit from all of the funds they invest in.

Types of Exchange Traded Funds

When it comes to the type of Exchange Traded Funds, there are numerous types of funds available. A few of the major examples are Index ETFs, Commodity ETFs, Bond ETFs, Currency ETFs, Actively Managed ETFs and Leveraged ETFs.

Exchange Traded Funds vs. Mutual Funds, what should I buy?

When it comes to the choice between investing in mutual funds or Exchange Traded Funds, the investor will have to consider a number of factors. An ETF transaction is normally subject to brokerage fees and thus small investments are not very cost effective unless the investor finds a discount offer with the broker. On the other hand the other fees associated with the ETFs are quite low which makes it a preferred option over mutual funds.

From taxation point of view the Exchange Traded Funds are preferred over the mutual funds. When a mutual fund has a capital gain it is distributed to the shareholders, while in case of ETFs, the holder can simple sell their funds on the stock market as they would have done with any other stock. An added advantage for investors of the United Kingdom is that they can safeguard their EFTs from capital gain tax by putting them in their ISA savings account or self invested personal pension (SIPP) as well as not attracting stamp duty charges.

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