Exchange-Traded Funds

The phenomenal growth of exchange–traded funds (ETFs) is a frequent topic in the financial press. These funds, with assets more than doubling each year since 1995, have been warmly embraced by most advocates of low–cost index funds. Vanguard, the leading advocate of index funds, has announced plans to add exchange–traded share classes to a number of its domestic index funds. Most of the press coverage has correctly noted the major advantages of ETFs—low–costs, intraday trading and high tax efficiency with no material premiums or discounts to the funds' intraday net asset value. However, there is a fair degree of misunderstanding about how ETFs work, what sectors of the market are good candidates for ETFs and what sectors are not, why the expense ratios tend to be low, and how most of the funds manage to avoid significant capital gains distributions. In this article, the author attempts to answer these and other questions frequently asked by investors.