funds, but can be bought and sold during the day just likevehicles allow investors a convenient way to purchase a broad basket of securities in a single transaction. Essentially,

Exchange-tradedfundsare some of the most popular and innovative new securities to hit themarketsince the introduction of themutual fund. The firstETFwas the Standard and PoorsDepositReceipt (SPDR, or Spider), which was first launched in 1993. Purchasing Spiders gave investors a way to mimic the performance of the S&P 500 without having to purchase anindex fund. Furthermore, because they traded like astock, SPDRs could be bought and sold throughout the day, purchased onmargin, or even sold short.

Whenever an investor purchases anETF, he or she is basicallyinvestingin the performance of an underlying bundle of securities — usually those representing a particularindexor sector. UnitInvestmentTrusts (UITs) are often organized in the same manner. However, the unusual legal structure of anETFmakes the product somewhat unique.

Exchange-traded funds dont sellsharesdirectly to investors. Instead, eachETFs sponsorissueslarge blocks (often of 50,000 shares or more) that are known as creation units. These units are then bought by an authorized participant — typically amarket maker, specialist orinstitutional investor– which obtains shares of theunderlying securitiesand places them in a trust. The authorized participant then splits up these creation units intoETFshares — each of which represents a legal claim to a tiny fraction of the assets in the creation unit — and then sells them on a secondary market.

Just as closed-end funds dont always trade at a price that precisely reflects the value of theunderlying assetsin each share of the portfolio, it is also possible for anETFto trade at a premium or a discount to its actual worth. Toliquidatetheir holdings, most investors simply sell theirETFshares to other investors on theopenmarket. However, it is possible to amass enoughETFshares to redeem them for one creation unit and then redeem the creation unit for the underlying securities. Because of the large number of shares involved, individual investors seldom use thisoption.

Exchange-tradedfundshave grown increasingly popular in recent years, and the number of offerings has swelled. Today, these securities compete withmutual fundsandoffera number of advantages over their predecessors, including:

Low Cost– Unlike traditional mutual andindexfunds,ETFshave no front- orback-end loads. In addition, because they are not actively managed, mostETFshave minimal expense ratios, making them much more affordable than most other diversifiedinvestmentvehicles. Mostmutual fundsalso haveminimum investmentrequirements, making them impractical for some smaller investors. By contrast, investors can purchase as little as one share of theETFof their choice.

Liquidity– Whereas traditionalmutual fundsare only priced at the end of the day,ETFscan be bought and sold at any time throughout the trading day. Many have average daily trading volumes in the hundreds of thousands (and in some cases millions) ofsharesper day, making them extremelyliquid.

Tax-Advantages– In a traditionalmutual fund, managers are typically forced to sell off portfolio assets in order to meet redemptions. Often, this act triggers, to which all shareholders are exposed. By contrast, the buying and selling of shares on theopenmarkethas no impact on anETFstax liability, and those that choose to redeem theirETFsare paid in shares ofstockrather than incash. This minimizes anETFs tax burden because it does not have to sell shares (and therefore potentially realize taxable capital gains) to obtain cash to return to investors. Furthermore, those who redeem theirETFsare paid with the lowest-cost-basis shares in thefund, which increases thecost basisfor the remaining holdings, thereby minimizing theETFs capital gains exposure.

Although exchange-traded fundsofferseveral advantages over traditionalmutual funds, they also have two distinct disadvantages. To begin, the securities that anETFtracks are largely fixed, so investors that preferprobably findETFswholly unsuitable. Furthermore, because they trade asstocks, eachETFpurchase will be charged a brokeragecommission. For those that make regular periodicinvestments– such as a monthly dollar-cost averaging investment plan — these recurring commissions might quickly become cost-prohibitive.

As with any security, the pros and cons should be weighed carefully, and investors should first do their homework to determine whether exchange-traded funds are the appropriate vehicle to meet their individual goals and objectives.

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