An ETF is most often an exchange-traded Index fund. An index fund is a type of mutual fund that is created to replicate the performance of a particular investment index like the S&P 500, the Russell 3000 or the Barclay’s Aggregate Bond Index.
Index funds have much lower annual fees than classic mutual funds because they do not need to employ analysts or portfolio managers to replicate an index.
Index funds are typically traded once a day after the market closes and are valued at their net asset value (NAV, the total value of the underlying securities held by the index fund divided by the number of shares outstanding). An ETF is exchange-traded which means it can be bought or sold at any time of the day during which the stock market is open. In other words, the value of an ETF fluctuates throughout the day based on the underlying value of the index it tracks. Thus you could pay $60 per share at 11:00 am and $59.63 at 11:04 am if the ETF’s underlying index dropped in value by 0.6% in the intervening 4 minutes.
ETFs typically have lower management fees than their index fund cousins until you invest a minimum amount in the index fund. For example, you typically need to invest at least $10,000 in a Vanguard index fund to get the same management fee as the comparable Vanguard ETF.
Because ETFs are exchange-traded there is a risk that the price you realize upon sale or purchase might be different from the Net Asset Value depending on the amount of trading volume (liquidity) in that particular ETF.
ETFs have been created to track stock markets for a variety of countries, bond markets for a variety of countries, currencies, commodities, and a wide variety of other indexes. In addition to index oriented ETFs (which represent the vast majority of the more than 1,400 ETFs issued to date), there also exist “exotic” ETFs that allow you to bet an index will decrease or add leverage to the returns of a particular index.
ETFs are best used as part of a responsible asset allocation plan which diversifies your portfolio across geographies and asset classes (types of investments).