Exchange-traded funds are a relative newcomer to mutual funds. Nicknamed "Spiders" because of their SPDR acronym, the first two ETFs, introduced in 1993 and 1995, are based on a Standard & Poor's stock index. SPDRs mimic the S&P500 index and Midcap SPDRs mimic the S&P Midcap 400 index.
ETFs track the performance of widely used stock indexes the way shares of traditional index funds do. ETFs have some advantages over index funds. For one, shares are traded throughout the day. Traditional mutual funds of the open-end variety redeem shares at the net asset value, which they set daily at 4 p.m. EST.
Another advantage is that you can arrange a short sale of an ETF, which you cannot do with shares of a mutual fund. A short sale, which is done through a brokerage margin account, involves borrowing shares from a broker, selling the shares and buying back the shares at a lower price. (You should consult a financial adviser to learn more about the risks of short-selling.)
Institutional investors can buy ETF shares directly from a fund by paying cash or depositing a basket of shares that resembles the underlying index. (The underlying index of the S&P Midcap400 SPDR, for example, is the S&P Midcap 400.) These shareholders are called creation-unit holders.
Individual investors buy ETF shares directly from the creation-unit holders in the stock market, using a brokerage account the way they would to buy ordinary shares of a company's stock.
ETFs provide the same advantages of diversification and low transaction costs that index funds offer. ETFs are also available for a variety of U.S. and international indexes, which allows you to invest in a wide range of sectors and countries at a relatively low cost. According to the Investment Company Institute, there were 613 ETFs at the end of November 2007 with total assets of $572 billion.