Traditional mutual funds are bought and sold based on their net asset value at the close of business each trading day, while ETFs can be traded throughout the day from market open to market close.
ETFs allow investors to diversify their holdings within a group of securities. For example, if you believe in the prospects of the biotechnology industry but would like to buy a diversified group of biotechnology stocks (rather than just one or two companies) for a relatively small sum, an ETF can help.
ETFs also may have lower costs than those of an actively managed mutual fund. Because of the passive management and structure of ETFs outlined above, it may have lower annual taxable distributions.
Because ETFs make the in-kind redemptions outlined above, an ETF doesn’t need to hold on to cash, which can lead to cash lag and cause the realization of capital gains or losses, as seen in mutual funds.
Unlike traditional mutual funds, ETFs can be sold short by investors. Generally, an investor buys a stock expecting the value to increase. Short sales, however, are different. An investor who believes that a particular stock will decline in value can borrow shares of that stock from a brokerage firm (for a fee) in what is known as a short sale. If the value goes down, the investor makes money; if the value goes up, the investor loses money. Keep in mind that the potential for unlimited losses makes short selling very risky. An ETF also can be bought on margin or traded using stop orders or limits orders.
ETFs also have no minimum investment requirements, or redemption fees for brief holding periods.