How Exchange-Traded Funds Work

ETFs in the Real World

As of 2011, there are more than 700 ETFs available on the market. Many ETFs are based on a market index (an index is a basket of related stocks that are tracked together and typically represent a specific economic segment or industry) such as the S&P 500 Composite Stock Price Index. In fact, the earliest ETF was made of S&P 500 assets and is known as SPDR, or Spider. Other market indexes include the Dow Jones Industrial Average, the NYSE Composite Index, and the Nasdaq 100 Index.

Which ETF you choose to invest in depends on your investment plans and goals. Each ETF is designed with a different goal in mind. For example, the Total Stock Market VIPERs ETF tracks a large number of U.S. companies, and therefore is considered a good way to track (and invest in) the overall U.S. economy. The iShares MSCI EAFE ETF gives investors shares in a range of foreign companies, so it's considered a good investment if you're looking to diversify your portfolio by buying international stocks.

Most ETFs aim to match the return of a market index, but there are other types. Leveraged and inverse ETFs strive to match a multiple of an index's return, or an inverse multiple of the index's daily return. These are more complex investments that should be researched thoroughly -- in fact, the SEC has issued a warning to investors because these types of ETFs can be confusing [source: SEC].

If you're looking to get into the ETF market, it's fairly easy to do since they're traded openly. ETFs have been steadily increasing in popularity since their introduction. However, since they're made up stock assets, their value has been negatively affected by overall economic downturns -- and they could face similar problems in the future. Of course, no investment is immune to this vulnerability. You should also note that buying and selling ETF shares is subject to the same brokerage fees you'd incur trading any other stock.

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