ETF Investing Basics - ETF Investing 101

Exchange traded funds (ETFs) made their debut on U.S. exchanges in 1993 with the debut of the SPDRS (NYSE: SPY), an ETF used to track the S&P 500. Fast-forward to the current day and there are about 1,000 exchange traded products available to U.S. investors, so it's fair to say that ETFs are one of the most significant financial products to come along in decades. New ETFs come to market on a weekly basis and there are now hundreds of billions under management by U.S. ETF issuers, so what appeared to be a fad in the 1990s has now become a staple of the U.S. investment lexicon.

Let's take a look at the evolution of the ETF industry. ETFs, at least at the outset, were intended to compete with mutual funds for investors' affection and to that end, equity-based ETFs are structured in similar fashion to mutual funds. Perhaps the biggest reason investors buy mutual funds is because they want exposure to a basket of stocks, but they simply cannot afford to buy every stock held by that fund. ETFs do the same thing. They give investors access to dozens or even hundreds of stocks at a price that makes sense.

Investors in equity ETFs are investing in a product that is linked to an index, so the holdings are always readily available and easy to track. In other words, ETFs are transparent investment products and with a couple of clicks of a mouse, you'll always know what you're investing in. Of course, you've probably heard that ETFs trade like stocks and that's true. This means that ETFs are superior to mutual funds in terms of liquidity and they are useful tools for both short-term traders and longer-term investors.

ETFs also offer lower expenses than mutual funds. In fact, the average expense ratio for a large-cap growth equity ETF is more than a full percentage lower than the comparable mutual fund. ETFs also offer superior tax benefits because investors rarely incur capital gains.

While there are dozens of varieties of mutual funds, ETFs are also the best alternative for playing several asset classes beyond stocks. Yes, the bulk of ETF assets do lie in equity funds, but ETFs are also the best way for conservative investors to gain exposure to commodities, foreign currency and a host of bearish strategies. In addition, investors looking to play emerging markets have the world at their fingertips as ETFs represent the best way to gain access to markets outside the U.S.

Not surprisingly, ETFs are excellent ways to build a portfolio that has optimal diversification and asset allocation. This objective can be accomplished with a relatively small amount of ETFs. To do the same thing with mutual funds or stocks, an investor would be forced to purchase an excessive amount of securities while incurring higher fees and expenses.

The bottom line is that ETFs are a revolutionary financial product that can be of enormous benefit to the so-called average investor. No portfolio should be without at least one or two ETFs.