Wouldnt it be nice to trade index funds intra-day instead of that once-a-day situation? No need to panic, you can now do this. Exchange Traded Funds or ETFs allow you to trade index funds like regular stocks. The proliferation of ETFs has been amazing over the past few years. Their popularity has been steadily increasing and with good reason.

They offer many advantages over buying traditional mutual funds or index funds. ETFs can be traded at any point during market hours like an individual stock. This is not the case with mutual funds, whose values are calculated once per day at the close of trading. They are also much more cost-efficient than mutual funds.

ETFS DEFINED

It would be beneficial to define what an ETF actually is. ETFs are securities certificates that state legal right of ownership over part of a basket of individual stock certificates. Several different kinds of financial companies are essential for ETFs existence. Laying all the groundwork is the fund manager. This is the main backer behind any ETF, and they must submit a detailed plan for how the ETF will operate to be given permission by the SEC to proceed.

The creation of an ETF officially begins with an authorized participant, also referred to as a market maker or specialist. Highly scrutinized for their integrity and operational competence, these middlemen assemble the appropriate basket of stocks and send them to a specially designated custodial bank for safekeeping.

LESS TAXING

These baskets are normally quite large, sufficient to purchase up to 50,000 shares of the ETF in question. The custodial bank ensures that the basket represents the requested ETF and forwards the ETF shares on to the authorized participant. This is a so-called in-kind trade of essentially equivalent items that does not trigger capital gains for investors. This is different than mutual funds, which never feel guilty about dumping big capital gains on their unsuspecting shareholders.

Because of the way they are created and redeemed, ETFs allow an investor to pay most of the capital gains upon the sale of the ETF, delaying it until the end. There is no way to avoid capital gains, but delaying it is valuable because the amount that would have been paid to taxes can continue to accumulate wealth. The power of compounding interest that captivated Albert Einstein so much has more time and room to work its magic.

A GREAT WAY TO SPREAD YOUR EGGS AROUND

The diversification potential of ETFs is one of their most attractive features. They are not limited to stocks at all. Any class of asset that has a published index around it and is liquid can be made into an ETF. Bonds, gold, and real estate are available now. Ben recently purchased the Barclay Ishares Comex Gold ETF for the Focus List, which is a great way to add gold to the portfolio. Why not just buy gold stocks? Well, gold stocks are very volatile and are susceptible to the whims of speculative investors. The gold ETF tracks the metal directly. It trades at one-tenth the price of an ounce of gold. This takes a lot of the risk out of investing in the gold sector, because the volatility of the price of gold is much less than the stocks in the sector.

SOMETHING FOR THE DARING INVESTOR

For you adventurous investors, these ETFs can be shorted as well. Obviously this is not the case with traditional mutual funds and index funds. If you are bearish on a certain country or a market index, the best way to play that is to short the appropriate ETF. Shorting is certainly not for everybody, but it can be a powerful tool for professional hedge fund managers, and ETFs provide a great means to do this for a variety of asset classes.