Exchange traded funds

Exchange traded funds (ETFs) are investment vehicles that are part individual security and part mutual fund. With an ETF, you buy and sell shares in an entire portfolio of securities — sometimes called a basket of securities — in the same way you buy and sell shares of a single stock. But, as you do with a mutual fund, you own shares of the ETF rather than shares of the underlying investments.

Each ETF tracks a particular index or sector and seeks to replicate its performance by owning the securities that make up the index or sector, no matter how broad or narrow a segment of the market it may be. Thus an ETF may include several dozen or sometimes several hundred or even several thousand securities. As the number of indexes continues to grow, there is an increasing variety of ETFs in which to invest.

In the United States, there's often only one ETF tracking each index. This helps avoid potential liquidity problems, which can be a concern if multiple ETFs hold large numbers or shares of the same securities and trade those securities at the same time when there are changes to the index.

Whose Choice?
Who determines the contents of an ETF portfolio? The ETF sponsor chooses the index that the ETF tracks but not the components of the index portfolio. In some cases, such as the Standard & Poor's 500 Index (S&P 500) and the Dow Jones Industrial Average (DJIA), it's the job of the index commitee members to analyze, select, and update the components. But in other cases, changes to an index, and consequently to the portfolio of an ETF that tracks it, are determined by a software program designed to identify securities that meet a specific set of criteria, such as the 1,000 U.S. companies with the largest market capitalization. That's what happens with the Russell 1000, for example.