Exchange Traded Funds -- ETFs -- are investment funds that have their shares traded on the stock exchanges. Investors buy and sell ETF shares in the same manner as buying and selling individual stock shares. ETFs are classified as investment companies as defined by the Investment Company Act of 1940. Mutual funds and closed-end funds are other types of investment companies.
As investment companies, ETFs have expenses including portfolio administration, bookkeeping, shareholder services and the fund administrator would like to make a profit. The expenses of an ETF are paid by the shareholders of the fund. The expense ratio is a percentage that represents the annual costs per share of the ETF expenses.
The expense ratio of an ETF is reported in the fund's prospectus and on its information web page. The ratio is listed as a percentage. For example, the expense ratio for the SPDR S&P 500 Index fund is 0.09 percent. During the course of a year the company that runs SPY will take 0.09 percent of the assets out in expenses.
ETFs are intended to mirror the investment return of a specific index or commodity price. The SPDR S&P 500 Index fund will hold the same stocks in the same proportion as are included in the S&P 500 stock index. The expenses paid from the ETF assets in the form of the expense ratio will reduce the investment return from the ETF when compared to the tracked index or commodity value.
ETFs do not attempt to beat the market with their investment returns. They are designed to match the return of the selected index. Different ETFs that track the same stock or bond index will have similar performance. Investors should compare the expense ratios of similar ETFs and give preference to the ETFs with lower expense ratios. Exchange traded funds with larger amounts of assets will usually have lower expense ratios, while new, smaller ETFs with have higher expenses.
The expense ratio is not the only cost of investing in exchange traded funds. ETF shares must be purchased through a regular stock brokerage account. There will be commissions to both buy and sell ETF shares. The commissions on buying and selling ETFs are the same as for buying and selling individual stocks. An investor who does a lot of trading in and out of ETFs will see a greater impact from brokerage commissions than from the expense ratios of the funds.
Tim Plaehn has been writing financial, investment and trading articles and blogs since 2007. His work has appeared online at Seeking Alpha, Marketwatch.com and various other websites. Plaehn has a bachelor's degree in mathematics from the U.S. Air Force Academy.