We often speak of Exchange Traded Funds (ETF's). Shell Capital Management has one of the longest running track records applying a global tactical rotation system to exchange traded securities. Exchange Traded Funds are securities that provide exposure to a wide range of markets and factors: bonds, stocks, currency, commodities, sectors, growth, value, etc. 

Index ETFs follow a specific benchmark index as closely as possible. Index ETFs are much like index mutual funds, but whereas the mutual fund shares can only be redeemed at one price daily, the closing net asset value (NAV), index ETFs can be bought and sold throughout the day on exchanges. Through an index ETF, investors get exposure to a large number of securities in a single transaction. Index ETFs can cover U.S. and foreign markets, specific sectors, or a specific class of stock (i.e. small-caps, ADRs, etc.) but all incorporate a passive investment strategy, only making portfolio changes when changes occur in the underlying index.

An exchange traded fund (ETF) is an investment vehicle that combines key features of traditional mutual funds and individual stocks. Like index mutual funds, ETFs represent diversified portfolios of securities that track specific indexes. Like stocks, they can be bought and sold (long or short) on an exchange throughout the trading day. In addition to trading flexibility, key ETF benefits include instant portfolio diversification, tax efficiency, and transparency of cost and holdings.

1. ETF Diversification: A benefit of ETFs is the fact that they are designed to track market indexes that may contain hundreds or even thousands of securities. This can offer ETF investors diversification of a typical index mutual fund with the trading flexibility of a stock. Any time during the trading day, an investor can execute a single ETF trade and obtain broad exposure to an entire asset class, country, region, or sector.

2. ETF Tax Efficiency:

Because ETFs seek to track market indexes, their turnover is typically lower than that of actively managed funds. Lower turnover can result in increased tax efficiency for investors when securities are sold at a gain. In addition, with traditional mutual funds, the buying and selling activities of some shareholders can trigger capital gains distributions for all of the fund's shareholders. For example when the fund must sell securities to raise cash in order to meet redemptions, any related capital gains are distributed to all remaining investors in the fund. Learn the differences between ETFs and actively managed funds.

In contrast, ETF trading occurs on an exchange just like stocks; there is no fund company in the middle. Thus ETF investors are generally insulated from the tax consequences of their fellow shareholders' actions and will primarily be affected when they decide to complete ETF trading by either buying or selling an ETF.

3. ETF Transparency:

Unlike many investment vehicles and investing strategies that only disclose their holdings quarterly, most ETF index funds publish their exact holdings on a daily basis, so you can always know what you own¹. ETF Transparency makes it easier to see exactly what you own and to respond accordingly to market activity.

¹ In accordance with MSCI licensing, holdings for MSCI-indexed funds are updated monthly.

The ETF Creation and Redemption Process:

While ETF trading occurs on an exchange like stocks, the process by which their shares are created is significantly different. Unless a company decides to issue more shares, the supply of shares of an individual stock trading in the marketplace is finite. When demand increases for shares of an ETF, however, Authorized Participants (APs) have the ability to create additional shares on demand.

Through an "in kind" transfer mechanism, APs create ETF units in the primary market by delivering a basket of securities to the fund equal to the current holdings of the ETF. In return, they receive a large block of ETF shares (typically 50,000), which are then available for trading in the secondary market. This ETF creation and redemption process helps keep ETF supply and demand in continual balance and provides a "hidden" layer of liquidity not evident by looking at trading volumes alone.

This process also works in reverse. If an investor wants to sell a large block of shares of an ETF, even if there seems to be limited liquidity in the secondary market, APs can readily redeem a block of ETF shares by gathering enough shares of the ETF to form a creation unit and then exchanging the creation unit for the underlying securities.

ETF's and Index Investing

Most ETFs are designed to track published market indexes. Index investing offers several benefits, including lower costs than most active management strategies and performance that seeks to track a benchmark. You can also learn about the differences between ETFs and actively managed funds. In addition, index funds are broadly diversified since they typically hold all or many of the securities within the index. This gives you "instant" diversification that can help manage portfolio risk versus holding one or just a few individual stocks.

Understanding how indexes differ is important to selecting the most appropriate ETF diversification strategy for an investor's specific objectives. For example, The Russell 2000 Index, a widely followed small-cap index, includes companies with smaller capitalizations than those in the S&P SmallCap 600, another popular index for small company stocks. Differences in individual index constituents can also give rise to different sector [or country/geographic] exposures from one index to another. The transparency of index holdings, characteristics and construction methodologies helps to ensure proper ETF selection.

Source: http://us.ishares.com/understand_etf/index.htm

To learn more, watch the video Exploring ETFs by iShares.