An investment sea change has been occurring in the past few years: Mutual fund investors have been shifting some or all of their assets to passively managed vehicles. For many, exchange-traded funds (ETFs) have become the vehicle of choice.

“An increasing number of investors are turning to ETFs to gain exposure to specific markets or to complement other holdings in their portfolios,” says Mariana F. Bush, CFA, a senior analyst with Wells Fargo Advisors.

And many of those investors have found plenty to like in the rapidly maturing field of ETFs. Since the first ETF was launched in 1993, the field has grown to nearly 1,200 different ETFs, with combined assets of $1.193 trillion as of March 31, 2012, according to the Investment Company Institute.

Built like a fund, traded like a stock

ETFs are a type of exchange-traded product (ETP), which is essentially what it sounds like: an investment that trades on exchanges. ETFs are generally designed to mirror the performance of certain market indexes, so they tend to be passively managed. A few actively managed ETFs exist, but when most people discuss ETFs, they’re referring to the index-based type.

Like mutual funds, most ETFs are registered investment companies. And like index mutual funds, passively managed ETFs attempt to mirror the performance of an index. Those indexes may reflect exposure to domestic or international markets; equity, fixed income, commodity or currency markets; or a broad or narrow exposure to those markets.

Unlike mutual funds, however, ETFs trade on exchanges and can be bought and sold at market prices throughout the day during market hours, like stocks. ETFs typically list their current holdings on a daily basis, whereas mutual funds generally disclose their holdings every quarter.

Other uses

Another advantage of ETFs is that the investment minimum is one share. This makes it easy for investors to try out investment themes or create targeted allocations without a significant investment of capital.

ETFs may be more tax-efficient than actively managed funds. ETFs may create and redeem their shares in kind, rather than in cash, which can help them avoid distributing year-end capital gains the way many mutual funds do. This is particularly true for more seasoned and liquid ETFs.

But like any powerful tool, ETFs need to be handled carefully. In particular, investors should understand exactly what a given ETF holds and how its underlying index really works during particular market environments. “The way futures contracts work is different from how stocks behave,” Bush cautions. “The same goes for ETFs that involve leverage. They can magnify or minimize market movements, and the mechanisms for how they do that can be complex.”

Evaluating ETFs

You should take the time to understand exactly what you’re buying and how it’s likely to behave under different conditions. Working with your financial advisor to select appropriate ETFs is likely to involve more than just a review of performance and expenses. Among other things, you’ll want to look at an individual ETF’s exposure and how it fits into the rest of your portfolio.

You’ll also want to examine a given ETF’s liquidity. This tends to be less of an issue for popular, heavily traded ETFs, but less liquid ETFs may be thinly traded and difficult to trade at a price that makes sense for your investment strategy.

• This article was written by Wells Fargo Advisors and provided courtesy of Ahwatukee financial advisor S. Kim DeVoss, CFP®. Reach her at (480) 940-5519. Investments in securities and insurance products are: NOT FDIC-INSURED/NOT BANK-GUARANTEED/MAY LOSE VALUE. Wells Fargo Advisors, LLC, Member SIPC, is a registered broker-dealer and a separate non-bank affiliate of Wells Fargo & Company.

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