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An exchange-traded fund (ETF) is a basket of securities you buy or sell through a brokerage firm on a stock exchange. ETFs are offered on virtually all asset classes ranging from traditional investments to alternative assets like commodities or currencies.

Exchange-traded funds are one of the most important and valuable products created for individual investors in recent years. ETFs offer many benefits and, if used wisely, are an excellent vehicle to achieve an investors investment goals.

Briefly, an ETF is a basket of securities that you can buy or sell through a brokerage firm on a stock exchange. ETFs are offered on virtually every conceivable asset class from traditional investments to so-called alternative assets like commodities or currencies. In addition, innovative ETF structures allow investors to short markets, to gain leverage, and to avoid short-term capital gains taxes.

After a couple of false starts, ETFs began in earnest in 1993 with the product commonly known by its ticker symbol, SPY, or Spiders, which became the highest volume ETF in history. There are now estimated to be over $1 trillion invested in ETFs and nearly 1,000 ETF products traded on U.S. stock exchanges.

Designed to track a particular index like the S&P 500 or NASDAQ

Designed to provide exposure to virtually every type of bond available; U.S. Treasury, corporate, municipal, international, high-yield and several more

Designed to provide exposure to a particular industry, such as oil, pharmaceuticals, or high technology

Designed to track the price of a commodity, such as gold, oil, or corn

Designed to track an investment style or market capitalization focus, such as large-cap value or small-cap growth

Designed to track non-U.S. markets, such as Japans Nikkei Index or Hong Kongs Hang Seng index

Designed to profit from a decline in the underlying market or index

Designed to outperform an index, unlike most ETFs, which are designed to track an index

In essence, debt securities backed by the creditworthiness of the issuing bank; created to provide access to illiquid markets and have the added benefit of generating virtually no short-term capital gains taxes

Innovative structures, such as ETFs that allow investors to trade volatility or gain exposure to a particular investment strategy, such as currency carry or covered call writing

An ETF is bought and sold like a company stock during the day when the stock exchanges are open. Just like a stock, an ETF has a ticker symbol and intraday price data can be easily obtained during the course of the trading day.

Unlike a company stock, the number of shares outstanding of an ETF can change daily because of the continuous creation of new shares and the redemption of existing shares. The ability of an ETF to issue and redeem shares on an ongoing basis keeps the market price of ETFs in line with their underlying securities.

Although designed for individual investors, institutional investors play a key role in maintaining the liquidity and tracking integrity of the ETF through the purchase and sale of creation units, which are large blocks of ETF shares that can be exchanged for baskets of the underlying securities. When the price of the ETF deviates from the underlying asset value, institutions utilize the arbitrage mechanism afforded by creation units to bring the ETF price back into line with the underlying asset value.

The appeal of ETFs to individual investors is:

Buy and sell any time of the day: Mutual funds, in contrast, settle after the market close

Lower fees: There is no sales load, however, brokerage commissions do apply

More tax efficient: Investors have better control over when they pay capital gains tax

Trading transactions: Because they are traded like stocks, investors can place a variety of types of orders (limit orders, stop-loss orders, buy on margin) which are not possible with mutual funds

While superior in many respects, ETFs do have drawbacks, including:

Trading costs: If you invest small amounts frequently, there may be lower-cost alternatives investing directly with a fund company in a no-load fund

Illiquidity: Some thinly traded ETFs have wide bid/ask spreads, which means youll be buying at the high price of the spread and selling at the low price of the spread

Tracking error: While ETFs generally track their underlying index fairly well, technical issues can create discrepancies

Settlement dates: ETF sales are not settled for 2 days following a transaction; that means as the seller, your funds from an ETF sale are not technically available to reinvest for 2 days.

Once you have determined your investment goals, ETFs can be utilized to gain exposure to virtually any market in the world or any industry sector. You can invest your assets in a conventional fashion using stock index and bond ETFs, and adjust the allocation in accordance with changes in your risk tolerance and goals. You can add alternative assets, such as gold, commodities, or emerging stock markets. You can move in and out of markets quickly, hoping to catch shorter term swings, much like a hedge fund. The point is, ETFs give you the flexibility to be any kind of investor that you want to be.

Innovation has been the hallmark of the ETF industry since its beginnings less than 25 years ago. Undoubtedly, there will be new and more unusual ETFs introduced in the years to come. While innovation is a net positive for investors, its important to realize that not all ETFs are created equal. You should investigate carefully before investing in any ETF, carefully considering all factors to ensure that the ETF you choose is the best vehicle to achieve your investment goals.

Take advantage of the ETF/ETP screener to help find relevant ETFs that match your investment objective.

Read more about our offering, available tools, and resources for ETFs.

Learn more about which ETFs/ETPs might be a good fit.

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Article copyright 2011 by Lawrence Carrel, Don Dion and Carolyn Dion. Reprinted and adapted from ETFs for the Long Run and The Ultimate Guide to Trading ETFs with permission from John Wiley & Sons, Inc. The statements and opinions expressed in this article are those of the author. Fidelity Investments® cannot guarantee the accuracy or completeness of any statements or data. This reprint and the materials delivered with it should not be construed as an offer to sell or a solicitation of an offer to buy shares of any funds mentioned in this reprint.

Exchange-traded products (ETPs) are subject to market volatility and the risks of their underlying securities, which may include the risks associated with investing in smaller companies, foreign securities, commodities, and fixed income investments. Foreign securities are subject to interest rate, currency exchange rate, economic, and political risks, all of which are magnified in emerging markets. ETPs that target a small universe of securities, such as a specific region or market sector, are generally subject to greater market volatility, as well as to the specific risks associated with that sector, region, or other focus. ETPs that use derivatives, leverage, or complex investment strategies are subject to additional risks. The return of an index ETP is usually different from that of the index it tracks because of fees, expenses, and tracking error. An ETP may trade at a premium or discount to its net asset value (NAV) (or indicative value in the case of exchange-traded notes). The degree of liquidity can vary significantly from one ETP to another and losses may be magnified if no liquid market exists for the ETPs shares when attempting to sell them. Each ETP has a unique risk profile, detailed in its prospectus, offering circular, or similar material, which should be considered carefully when making investment decisions.

The data and analysis contained herein are provided as is and without warranty of any kind, either expressed or implied. Fidelity is not adopting, making a recommendation for or endorsing any trading or investment strategy or particular security. All opinions expressed herein are subject to change without notice, and you should always obtain current information and perform due diligence before trading. Consider that the provider may modify the methods it uses to evaluate investment opportunities from time to time, that model results may not impute or show the compounded adverse effect of transaction costs or management fees or reflect actual investment results, and that investment models are necessarily constructed with the benefit of hindsight. For this and for many other reasons, model results are not a guarantee of future results. The securities mentioned in this document may not be eligible for sale in some states or countries, nor be suitable for all types of investors; their value and the income they produce may fluctuate and/or be adversely affected by exchange rates, interest rates or other factors.

ETFs are subject to market fluctuation and the risks of their underlying investments. ETFs are subject to management fees and other expenses. Unlike mutual funds, ETF shares are bought and sold at market price, which may be higher or lower than their NAV, and are not individually redeemed from the fund.

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