All of the acronyms in the world of finance can be confusing, and one that investors don't always fully understand is ETFs, or exchange traded funds.
An ETF is really just like a regular mutual fund but its shares are traded on the stock exchange at a moment's notice, all day long. This differs from a traditional mutual fund that can only be purchased or sold at precisely 4 p.m. each day.
In most cases, ETFs that are focused on the stock market represent ownership of a set basket of companies. This basket of stocks is passively-chosen, rather than manager-selected. For example, the most popular ETF around tracks the investment return of the 500 individual stocks held inside the S&P 500 index. But, with thousands of ETFs in existence, investors can now find one that mimics the return of almost any tiny corner of the financial markets.
ETFs are attracting an ever-growing audience of fans. Proponents cite some obvious advantages ETFs have over traditional mutual funds. First, ETFs can be more tax efficient. Second, they can be traded very cheaply with many brokerage firms. Finally, they certainly allow investors to get instant diversification or shed market exposure with just a click of the mouse.
However, ETFs do have some vocal critics. For those who follow a long-term approach to investing, the idea of having to wait around until 4 p.m. to buy or sell - and transact only at that one price - isn't all that burdensome. Additionally, many believe that ETFs promote a short-term mentality that results in casino-like financial markets.
While both sides make valid points, I would say more attention needs to be paid to the possible distorting effect ETFs might be having on markets. Financial markets function best when investors think independently. Through independent and thoughtful behavior, their work helps markets arrive at a "best guess" aggregate opinion of the value of each individual financial security - stocks, bonds, etc.