Chances are, you’ve probably heard of ETFs. Maybe you own some of them in your investment accounts, maybe you’ve read about them in the paper. They’re tough to miss.

"I've been working with ETFs so long...I started using them before people even knew how to spell ETF!" ~Unattributed

That’s a joke you’ll hear from time to time around the money management industry. Yes, it’s terrible.

Nonetheless, the question -- What is an ETF? -- is quite common. As with many things in finance, there is simple layer of information that most investors should understand, and a decidedly more complex set of details that sit below the surface. The goal of today's Continuing Your Education, as always, is to simplify and summarize what is the most important.

The Basics

So let's start at the top. I think the most important piece of information to understand regarding ETFs is what the legal structure of the investment vehicle actually is. By in large, an ETF is an Open-Ended Mutual Fund. You can read more about mutual funds here.

While not all ETFs fall into that category (ETFs that invest in commodities and commodity futures, for example, are not structured as mutual funds), the majority of them do and, remember -- we're keeping things simple.

ETFs are structured as investment companies under the Investment Company Act of 1940 (sometimes just called the 40 Act), and those investment companies issue shares that allow those who purchase them the ability to participate in a pool of specific investments.

In other words, owning shares of an ETF is simply pooling your money with others to have access to a broad portfolio of investments, just like a mutual fund.

You have no idea how many financial professionals fail to grasp this simple concept, let alone the average investor. Over the years, I have received countless objections from people that actually manage other people's money saying they refuse to use ETFs because they didn't understand how they worked.

A Major Difference

"If they're basically the same thing as mutual funds, Mr. Smarty Pants, then why are they considered so innovative?"…is probably what you’re saying right now.

Good question! There are differences, and the most important one is spelled out right in the name. ETF stands for Exchange Traded Fund, and the E and the T explain the biggest distinction between ETFs and traditional mutual funds.

When you purchase or sell shares of a mutual fund, you transact that business directly with the fund company, and those transactions can only occur at the close of business each day. Shares of an ETF are bought and sold on an exchange just like a stock, and they trade all day long while the market is open for business.

In order to have this distinction, ETFs are required to receive exemptive relief from regulators. For more on this special rule of exemptive relief, click here.

This allows ETFs two major advantages over its ancestor - vastly more liquidity and control over ownership of the asset, and lower back-office costs for the fund provider. We'll come back to that cost advantage in a moment.

As with many extraordinary innovations, the ETF is less a dramatic and new invention in the world of finance, but more an improvement on an already existing product.

How About the Types of ETFs Available?

There are so many! ETFs have taken the art of subdividing large groups of investments into smaller, bite size pieces to a new level.

Again, the main flavors available to investors are going to fall into these categories (similar to mutual funds):

1. Stocks

2. Bonds

3. Real Estate

4. Commodities

5. Other financial instruments

But you can also get just about any specific subset of the above categories if your heart desires. Would you like to invest in the total stock market of the United States? There is an ETF for that. How about just small cap companies in Germany? You bet. There are even a few different ETFs that invest only in pure gold bullion.

You can’t go a day without hearing about the S&P 500 and how it performed on any given day. The granddaddy of all ETFs, SPY, was designed to allow investors a way to easily invest in the S&P 500.

In addition to the wide selection of investment themes covered by ETFs, the providers have gotten really creative with matching those themes with clever ticker symbols. If you want to invest in companies that specialize in the wind energy business, FAN will get the job done. EGPT, naturally, will let you target companies that have their home base in the country of Egypt, and JO or CAFE can get you invested in futures contracts tied to the price of coffee.

Another Important Distinction

Because of the added liquidity and the ability to purchase and sell ETFs all day on an exchange, you will be required to open up a brokerage account in order to buy and sell an ETF.

Unlike a mutual fund, you cannot purchase shares of an ETF directly from the fund company. Purchasing securities in a brokerage account comes with the downside of having to pay commissions, but the good news is that many online brokerage firms -- TD Ameritrade, Charles Schwab, and E-Trade -- have a list of commission free ETFs you can use.

More Advantages...

ETFs have a clear advantage in the internal cost arena versus their older contemporary, the mutual fund.

Mutual Funds (including ETFs) have internal fees expressed as an “expense ratio” and are used to pay for professional portfolio managers, accounting, administration, legal fees, and record keeping.

Without getting too deep into the subject, ETFs have no need for shareholder record keeping since the shares must be held in a brokerage account. Also, ETFs are generally index funds that don't require an expensive portfolio manager to make decisions on buying and selling the underlying investments.

The fact that ETFs tend to be index funds also provides an advantage of generally being more tax efficient than actively managed mutual funds. In fact, ETFs have a couple of different layers in the tax efficiency department: 1) The low turnover of underlying securities, and 2) The ability to move securities out of their portfolio with in-kind transactions.

We won't go deep into a discussion of the mechanics of the the creation/redemption process of ETFs in this post, but watching this video from iShares gives a very easy to follow explanation.

Let's Talk About Some Disadvantages

While I think it's pretty clear that the ETF has created some amazing improvements upon the classic mutual fund, it does come with some disadvantages.

Chief among them is the need to pay commissions for every buy or sell transaction. This can make an ETF a less than ideal solution for investors looking to invest small sums of money over a long period of time, like in a 401k account with their company. Traditional mutual funds still rule the roost in the defined contribution world for a reason.

Also, buying and selling an ETF in a brokerage account without some modest understanding of trading - such as limit orders, market orders, bid/ask spreads, to name a few - can be a huge hurdle for the average investor.

Always seek help from a professional if any of these items I mentioned look foreign to you or make you nervous.

Let's Bottom Line This, Jeff...

ETFs have been hailed as one of the greatest innovations in the investing world in the last 25 years, and for good reason. They took a great idea already in place, the mutual fund, and improved on it. They made owning a diversified basket of stocks, bonds, or commodities less expensive and more tax efficient for the average investor.

For those reasons alone, I am a true believer that the investment management industry has been forever changed and changed for the better due to the invention of the ETF. Rest in Peace, Nate Most — your legacy is a strong one.

Additional Reading:

The History of Exchange Traded Funds - ETFGuide

How the US Government Inadvertently Launched a $3 Trillion Industry - Bloomberg

Full Disclosure: Nothing in this post should ever be considered to be advice, research or an invitation to buy or sell any securities.