Basics: Fun with Exchange-Traded Funds (ETFs)

Exchange-Traded Funds (ETFs) are relatively new to the US market, having been introduced only in 1993. ETFs allow investors to follow the performance of key indices and sectors while providing the flexibility and instant liquidity lacking in traditional mutual funds.

There was a time when mutual funds were the most accessible entry to professionally-managed diversification. However, professional management has a price, and after the active managers have collected their paychecks, approximately 80% of mutual funds underperform the average stock market return. (Index funds, which are automated mutual funds that track a stock market index, have lower annual fees – but that is an article for another day.)

ETFs differ from mutual funds in that they can be traded like a stock. ETFs allow intraday trading, unlike mutual funds, which are only traded for the net asset value at the end of the day. The fact that ETFs are traded like stocks also means that they can be shorted, bought on margin, or placed on limit orders. Options are also available.

Finally, ETFs have tax benefits over traditional mutual funds. Actively managed fund shareholders pay taxes on all the capital gains that the fund owns while they hold their shares, as opposed to just paying taxes on their personal capital gains.

Now, onto the ETFs. There are more than 300 of them, and here are some of the most popular ones:

1. SPDRs State Street Global Advisors (SPY) – tracks the S&P 500
2. PowerShares QQQ (QQQQ) – tracks the NASDAQ-100 index
3. iShares Russell 2000 Index Fund (IWM) – tracks the Russell 2000 index

Here are a few that I am partial to:

1. streetTRACKS Gold Shares (GLD) – invest in gold without the risk of buying gold futures or the hassle of storing gold bricks in your home
2. SPDR S&P Metals & Mining (XME) – tracks the S&P Metals & Mining index
3. iPath S&P GSCI Crude Oil Tot Ret Idx ETN (OIL) – tracks the Goldman Sachs Crude Oil Return Index

Lately, it has been easier to target sectors to stay away from than ones to invest in. These bear-market ETFs can do the shorting for you:

1. UltraShort Financials ProShares (SKF) – corresponds to the inverse of the Dow Jones US Financials index
2. UltraShort Real Estate ProShares (SRS) – corresponds to the inverse of the Dow Jones US Real Estate index
3. UltraShort FTSE/Xinhua China 25 Proshare (FXP) – corresponds to the inverse of the FTSE/Xinhua China 25 index
4. Rydex Inverse 2x S&P 500 (RSW) – corresponds to the inverse of the S&P 500

All of these can be traded an AMEX, NYSE, or NASDAQ.