ETF stands for Exchange Traded Fund.

ETFs are listed on various exchanges like the New York Stock Exchange (NYSE), BATS Exchange, or NASDAQ. An ETF is a portfolio of securities, much like a mutual fund. ETFs can be based off an existing index, or can be a unique mixture of holdings determined by the fund manager. When traded, ETFs act like a stock: An investor can trade an ETF during market hours like trading a share of an equity. Simply call up a broker or log onto an online brokerage and put in an order.

ETFs possess two different types of liquidity, making them easily tradable. First, ETF shares are bought and sold like a stock on an exchange, making it easy for investors to trade the ETF. Second, ETFs possess an underlying liquidity due to their unique creation and redemption process, so low trading volume should not impact an investor’s ability to trade the ETF during market hours.

Index (or Passive) ETFs may offer tax advantages relative to mutual funds due to their structure and unique creation and redemption process. The creation and redemption processes used by index ETFs are designed to mitigate adverse effects on an ETF’s portfolio that could arise from frequent cash purchase and redemption transactions that affect the net asset value of the ETF.

In contrast to conventional mutual funds, where frequent redemptions can have an adverse tax impact on taxable shareholders because of the need to sell portfolio securities which, in turn, may generate taxable gain, the in-kind redemption mechanism of an index ETF, to the extent used, generally is not expected to lead to a tax event for shareholders.

Other possible tax implications may occur when shares are sold in the secondary market or a creation or redemption unit is created. Tax consequences will vary by individual.

Index (or Passive) ETFs are tethered to an underlying index, like the S&P 500 or Dow Jones Industrial Average. Fund management is focused on matching the underlying index, instead of making decisions based on research. A passive ETF follows its underlying index as its benchmark.

Active ETF management is based on research and the portfolio manager’s discretion with the investment policies of the ETF, as with an active mutual fund. Most ETFs in the active space are based on pre-existing strategies, just in a different wrapper. Because the manager is picking stocks based on research, actively managed funds are not tethered to an index.

An ETF is similar to a mutual fund in that it offers investors a proportionate share in a pool of stocks, bonds, and other assets. Also, like a mutual fund, an ETF is required to post the marked-to-market net asset value (NAV) of its portfolio at the end of each trading day. One major difference is that investors buy and sell ETF shares on a stock exchange through broker-dealers, much as they would trade individual stocks. In contrast, mutual fund shares are not listed on stock exchanges. Retail investors buy and sell mutual fund shares through a variety of distribution channels, including directly from a fund company or through a financial adviser or broker-dealer.

Mutual funds and ETFs are also priced differently. Mutual funds are “forward priced.” Investors can place orders to buy or sell shares throughout the day, but all orders received during the day will receive the same price—the fund’s NAV at the next time it is computed. Most mutual funds calculate their NAV as of 4:00 p.m. Eastern time because that is the time U.S. stock exchanges typically close. In contrast, the market price of an ETF share is continuously determined through trading on a stock exchange. Consequently, the price at which investors buy and sell ETF shares may not necessarily equal the NAV of the portfolio of securities in the ETF. In addition, two investors selling the same ETF shares at different times on the same day may receive different prices for their shares, both of which may differ from the ETF’s NAV. (Source: Investment Company Institute.)

Liquidity
ETFs trade on an exchange like a stock, thus they have similar liquidity and investors can trade them throughout market hours.

Transparency
ETFs disclose their holdings daily. Passive ETF holdings should reflect the index to which they are tethered. Active ETFs are similarly transparent and required by the SEC to disclose the holdings everyday. Mutual funds are not required to disclose their holdings daily, and stocks are naturally transparent as a single security.

Diversification
ETFs are packaged and sold as a unique collection of securities. Holding one ETF could offer an investor exposure to hundreds of securities, instead of just buying and selling individual stocks and bonds.

Tax Efficiency
The ETF creation and redemption process, which uses in-kind transfers of securities, makes index ETFs relatively more tax efficient when compared to mutual funds and stocks. Mutual funds are taxed when a manager sells securities within the fund and a capital gain is distributed. A tax must be paid on a stock every time it is sold.