The best way to begin to understand what ETFs are is to think about index funds (reading this post will help). Essentially, at their most basic level, ETFs are index funds. Their purpose is to track a particular market index, like the S&P 500 or the Dow Jones Industrial Average. The difference is in how they are traded.
A little ETF background
The first ETF, the SPDR fund, showed up in 1993 and was concerned with tracking the S&P 500. They’ve expanded from there, now number in the hundreds, if not over 1,000, and track much more than just the S&P 500. These funds were originally devised as a fancy tool for financial institutions, due to their ability to access much more information about the individual companies that make up an ETF than the average citizen had back in 1993. Nowadays, a regular consumer has much better access to the same kind of info, and as such the popularity of ETFs with the regular Joe off the street has grown.
So they’re different from Index funds how…?
ETFs are actually a collection of securities (something that can be traded on a market, like a stock or a bond), that track an index, but ETFs themselves are traded on the stock market just like an individual stock is.
This means several things. The biggest difference is the amount of flexibility an ETF offers. Since they’re treated just like a stock, and their price fluctuates throughout the day, day traders can get in on the action here. An index fund’s price is adjusted just once, at the end of the trading day.
There are also various techniques that can be applied to ETFs, such as buying on margin, which means borrowing money to buy stocks in hopes of getting a better return, and selling short, which is almost the opposite of buying on margin, meaning you borrow shares, sell them, and hope you can replace them with cheaper shares when the market falls.
ETFs may have more options and greater flexibility than low-cost index funds, but these are only benefits if you have the kind of investment strategy of any other guy who invests in individual stocks or likes to have a much more active position in his investments. I myself love the buy-and-hold-and-forget kind of strategy, where I invest in the broad, overall market, with a set amount of money every month, and will do so for quite a few number of years.
That’s not to say that I won’t have other investments on the side, or I won’t play around with a little cash every now and again to try out a different type of strategy, but overall, this is the strategy I buy into, as far as the stock market is concerned anyway.