ETFs (Exchange Traded Funds) are the rising stars of the investing world. While mutual funds were the investment of choice for most individual investors during the 1980s and 1990s, ETFs are steadily becoming the most popular investments of the 2000s.

ETFs can perhaps best be described as the perfect blend between stocks and mutual funds. When you buy an ETF, you get all of the same benefits of diversification you get when you buy a mutual fund, but you can buy and sell an ETF just like you can a stock.

How an ETF (Exchange Traded Fund) Works

An ETF is a firm that accepts money from investors and then employs a fund manager to invest that money according to the rules that have been developed for that particular fund. For instance, if you put your money into an ETF that tracks the S&P 500, the fund manager would take your money—and the money from all of the other investors in the ETF—and buy all of the stocks that comprise the S&P 500.

Most ETFs track market indexes (like the Dow Jones Industrial Average), market sectors (like the Financial Services sector) or specific commodities (like gold) so the fund manager doesn't have to do a lot of analysis and extra work to determine which stocks or assets to buy. However, there are an increasing number of actively managed ETFs coming out on the market that require the fund manager to play a much more active role.

When you put money into an ETF, you are buying shares of that fund. As the entire fund increases in value, your shares also increase in value. As the entire fund decreases in value, your shares also decrease in value.

Benefits of Investing in ETFs

Investing in ETFs has many benefits for individual investors, like you. Some of the benefits you could enjoy are:

- Instant diversification

- Access to commodities and other assets

- Easy implementation

Drawbacks of Investing in ETFs

Investing in ETFs also has a few drawbacks. Some of the drawbacks are:

- Fees (Although they are typically lower than the fees charged by mutual funds)

- Taxes (Although mutual funds typically have a higher tax burden)

- Potential of underperforming the market

Video: What are ETFs?

Now that you've got the basics of what an ETF is, check out the video below and see what else you can learn about ETFs at the whiteboard.

Taking Your Next Step

Once you're comfortable with ETFs, it's time to move on and learn about Opening the Right Investment Account for You.

Related Articles & Videos

- Stocks: What are Stocks

- Mutual Funds: What are Mutual Funds

- Diversification