ETF Investing

Exchange-traded funds, or ETFs have grown increasingly popular in recent years, and the number of offerings has dramatically increased.  Investors have poured around $1 trillion into these investments.  Today, approximately 45% of the overall exchange volume is represented by ETFs.

Essentially, an ETF is a mutual fund that trades like a stock.  Investors can buy an entire market sector at once.  When an investor purchases shares of an ETF, he or she is essentially investing in the performance of an underlying group of securities.  These securities typically represent a specific index or market sector.

ETFs now compete with traditional mutual funds and offer a number of advantages for which the average investor can take advantage.

Low cost: Generally speaking, ETFs are much lower in cost because they have no front-end or back-end loads like traditional mutual and index funds.  Furthermore, since ETFs are not actively managed, they have minimal expense ratios when compared with mutual and index funds, making them much more affordable than most other diversified investment vehicles.

Diversity: Virtually every sector is covered — including equity, fixed income and commodities — among the 1,000-plus ETFs available.  Most exchange-traded funds represent a broadly diversified index such as the Standard & Poor’s 500.  This collection of securities is grouped together and then sold on an exchange.

ETFs are efficient, so much so that traders are increasingly trading them electronically and that can lead to a phenomenon like the so-called May 6, 2010 “flash crash,” when the Dow dropped nearly 1,000 points within 15 minutes, and one out of four ETFs fell 60% percent or more, according to The Wall Street Journal.  Nearly 70% of the trades that were canceled that day were ETFs because they were not accurately priced.

In order to prevent this problem from happening again, the Securities and Exchange Commission approved the enactment of new trading circuit breakers and extended them to approximately 350 ETFs as well as all the stocks in the Russell 1000 Index.  The SEC also approved a circuit breaker pilot program to stocks listed in the S&P 500.  Here’s how it works: A 10% price change in a security within a five-minute period triggers the circuit breaker, which halts trading in that security for five minutes, giving “the markets an opportunity to attract new trading interest in an affected stock, establish a reasonable market price and resume trading in a fair and orderly fashion,” according to the SEC.