By Kris Wallace, Scottrade Investment Products Manager

Investing in any asset requires three things: a time horizon, knowledge of your investment and a outlook for success. Investing in ETFs is no different. I am going to assume you know two of these three things. What I would like to do in this piece is help you with the "knowledge of your investment" part and give you a basic understanding of an ETF.

Keep in mind, the ETFs I'll discuss here are traditional ETFs. For more information about leveraged and inverse ETFs, click here.

ETFs Explained

Well, what is an ETF? ETFs are similar to a mutual fund that trades every day on an exchange just like a stock or listed bond. They are an equal ownership of a portfolio that could consist of stocks, bonds, swaps, futures, options, plus other assets that are held by an investment firm.

Just like a mutual fund, you benefit from the gain of the underlying assets and you share equally in the losses. Just like a mutual fund, you pay an annual fee for the investment firm to purchase, hold and manage these assets for you. Just like a mutual fund, these investments are an open-ended fund that can be redeemed at the stated Net Asset Value (NAV). Just like a mutual fund, the NAV represents very closely the underlying pool of assets.

However, unlike a mutual fund, these investments can be bought and sold any time you can buy and sell a stock because they all trade on an exchange, such as the New York Stock Exchange, for example, just like stocks and closed-end funds. Also, unlike closed-end funds, ETFs typically do not trade with any discount or premium.

Advantages & Disadvantages

Here are some advantages to the ETF investment structure (keep in mind this is a broad description):

• Expense ratios tend to be lower than mutual funds and closed-end funds.
• ETFs can be tax-efficient investments due to many having passively managed portfolios.
• ETFs are continuously priced during the day because they are traded on exchanges, which allow any investor to liquidate their holdings. To do that, Scottrade customers can call their Scottrade broker or use one of the robust Scottrade online applications.
• ETFs do not charge annual 12b1 fees that mutual funds charge. Lack of annual fees can boost your year-over-year return by keeping more of your funds invested.
• ETFs cover a broad range of investments. Some ETFs have broad diversification - for instance, a total world market index ETF - while others narrow the focus to one commodity or currency. This can give an investor the power to tailor-make their own portfolio into something that fits their future investment goals (e.g., retirement, education, buying a home, to name a few).
• ETFs have the unique position of having option contracts. Options can offer you the opportunity to help manage specific risks and employ sophisticated investment strategies.

Here are some disadvantages to the ETF investment structure (keep in mind this is a broad description):

• Some recent ETFs involve the use of leverage. In this situation, leverage means investing with borrowed money. Great care must be used when investing in any leveraged investment because leverage magnifies gains and losses and can substantially increase an investor's risk.
• Some ETFs have a high concentration in just a few underlying assets. There may be no reason to pay an investment firm a yearly fee if you could easily invest in the underlying assets yourself for less money. (Some investors use these high-concentration ETFs in order to have an exposure to them after a tax loss sale, which could be positive.)
• ETFs have the unique position of having option contracts. While you may find options to be a good fit as an investment or risk management tool, the risks associated with options mean their use might not right for everyone. Options involve special risks that may expose you to potentially rapid and substantial losses. When considering the use of options, you should determine how it fits your own investment philosophy and fully understand the rules and requirements.

Scottrade and ETFs

Scottrade offers an Exchange-Traded Fund Quotes and Research section on our Web site. The front page is your portal to better understanding ETFs:

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In addition, our enhanced Knowledge Center can provide you with even greater detail and rich history into ETFs.