3.4. Exchange-Traded Funds (ETFs)

Exchange-traded funds, or ETFs, are a type of fund that contains stocks, bonds, or other assets. Generally, assets in an ETF are selected so that they track an index.

ETFs track an index by owning a basket of representative investments from the index. The idea is that the performance of a sample of investments will be similar to the performance of the index as a whole. The basket of securities is held by a custodian. The custodian issues a fixed number of shares that can be purchased by shareholders.

Some ETFs track broad indexes, others track narrower, sector- or geographic-specific indexes. ETFs track a variety of assets including equities, debt securities, commodities or currencies. Most ETFs are registered as investment companies, but this is not always the case. Some ETFs, especially those that track commodities or currencies may not be.

ETFs tend to track their indexes well, but tracking is inherently imperfect due to such issues as cash held, fund fees, and the liquidity of the assets within the fund. Thus ETFs subject their investors to tracking risk, also called tracking error, which is the risk that the fund will not adequately mimic the index.

ETFs are bought and sold on an exchange through broker-dealers just like stocks. This means that they can be bought and sold throughout the trading day, and if an investor believes that the market as a whole will move in the short term, by trading ETFs an investor can act on this prediction quickly. This is different from mutual funds that can only be purchased at the published price based on the NAV that is only calculated once a day, at the market close.

Unlike many mutual funds, there are no minimum investments with ETFs: you can buy or sell just one ETF share, which is great for small investors.

ETFs can also be sold short if the investor thinks the whole market will decline. This means an investor can borrow shares of the ETF from their broker, and sell t