Taking the Mystery Out of Exchange-Traded Funds

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As much publicity -- good and bad -- as exchange-traded funds have gotten recently, the ETF world remains a mystery to many. A Charles Schwab study found that overall understanding of the investments remains elementary, with nearly half of investors calling themselves “novices" when it comes to ETFs and only 8 percent considering themselves "experts."

With 1,484 (and counting) ETFs holding $1.5 trillion in assets in the U.S., learning about ETFs is worth the time. The funds have opened up access to investors in all areas of the market through low-cost, tax-efficient, transparent vehicles that trade like equities. In short, ETFs have leveled the investing playing field as individual investors now have the same tools at the same cost as institutions.

Why are ETFs hard to understand? Like mutual funds, they stretch into every nook and cranny of the investable universe. An investor needs some knowledge of a wide range of financial markets, including stocks, bonds, commodities, derivatives and international markets.

Beyond that similarity, it gets trickier. The way ETFs trade and how their shares are created and destroyed in the (rather biblically named) creation/redemption process are among the ways they differ dramatically from mutual funds.

Plain-English Resources

Below are a few of the most helpful plain-English resources for investors who want to demystify exchange-traded funds.

Websites: A popular website for all things ETF is www.etftrends.com, a one-stop shop of easy-to-digest pieces on any and every ETF out there. Many articles provide embedded links to other useful sites, making this a particularly good first stop. It has an easy-to-find and comprehensive education center. Other popular sites, aside from bloomberg.com itself, include www.indexuniverse.com, www.etfdb.com and www.morningstar.com.

Books: "ETFs for the Long Run," by Lawrence Carrel, benefits from the author’s storytelling ability. Carrel, a journalist, gets readers hooked on the narrative and characters involved in the invention of the ETF and all the battles along the way. While it's one of the least text-bookish books on the funds, Carrel provides a healthy dose of information on the mechanics and structure of ETFs as well as how to use them for asset allocation.

For those who want more advanced information, "The ETF Handbook," by David J. Abner, is a comprehensive look at the valuation, trading and liquidity of ETFs. It includes a thorough tour of the creation/redemption process, which is often a stumbling block for investors new to ETFs.

Podcasts: On the audio front, a popular educational podcast is “The ETF Store Show.” It's hosted by an amiable group of investment advisers and is aimed at individual investors. The show is constantly comparing ETFs with mutual funds, breaking down industry jargon and trumpeting the importance of asset allocation. The site gives access to all the podcasts.

Videos: iShares' YouTube channel contains short videos on a wide variety of educational and trending ETF topics. One of the most popular clips is a cartoon called “The Story of ETF Creation and Redemption.” ("This is not a prison movie narrated by Morgan Freeman," says the narrator.) The clip uses the analogy of a florist to describe the mechanics of ETFs.

Finally, remember that you or your adviser can always ask questions. Self-directed investors can call ETF issuers directly. They will actually pick up the phone and help you. Don’t be afraid to ask something basic -- as in all of the investing world, there is no such thing as a dumb question.

Eric Balchunas is an exchange-traded-fund analyst at Bloomberg. More ETF data are available here; Bloomberg ETF podcasts can be found here.

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