Exchange-Traded Funds1

Exchange-Traded Funds (ETFs) offer public investors an undivided interest in a pool of securities and other assets. ETFs are similar in many ways to traditional mutual funds, except that shares in an ETF can be bought and sold throughout the day like stocks on a securities exchange through a broker-dealer like LPL Financial. Unlike traditional mutual funds, ETFs do not sell or redeem their individual shares at net asset value. Instead, financial institutions purchase and redeem ETF shares directly from the ETF, but only in large blocks, varying in size by ETF from 25,000 to 200,000 shares, called "creation units." Individual purchasers trade them on the markets in which they are available.

ETFs generally provide the diversification, low expense ratios, and tax efficiency of index funds, while still maintaining many of the features of ordinary stock, such as limit orders and short selling. Because ETFs can be acquired, held, and disposed of, some investors invest in ETF shares as a long-term investment for asset allocation purposes.

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Advantages of ETFs

Lower Costs

ETFs may have lower costs than other investment products because most ETFs are not actively managed and because ETFs are insulated from the costs of having to buy and sell securities to accommodate shareholder purchases and redemptions. ETFs typically have lower marketing, distribution and accounting expenses, and most ETFs do not have 12b-1 fees.

Buying and Selling Flexibility

ETFs can be bought and sold at current market prices at any time during the trading day, unlike mutual funds and unit investment trusts, which can only be traded net asset value (NAV) at the end of the trading day. As publicly traded securities, ETF shares can be purchased on margin and sold short, enabling the use of hedging strategies, and traded using stop orders and limit orders, which allow investors to specify the price points at which they are willing to trade.

Tax Efficiency

ETFs generally generate relatively low capital gains, because they typically have low turnover of their portfolio securities. While this is an advantage they share with other index funds, their tax efficiency is further enhanced because they do not have to sell securities to meet investor redemptions.

Market Exposure and Diversification

ETFs provide an economical way to rebalance portfolio allocations and to "equitize" cash by investing it quickly. An index ETF inherently provides diversification across an entire index. ETFs offer exposure to a diverse variety of markets, including broad-based indexes, broad-based international and country-specific indexes, industry sector-specific indexes, bond indexes, and commodities.

Transparency

ETFs, whether index funds or actively managed, have transparent portfolios and are priced at frequent intervals throughout the trading day.

Some of these advantages derive from the status of most ETFs as index funds.

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What Else Should I Know About ETFs?

ETF Details

ETFs offer shares that trade in the secondary market. Because ETFs are listed on exchanges, individual ETF shares can be bought and sold throughout the trading day at the current market price. The general level of stock or bond prices may decline, thus affecting the value of an equity or fixed income exchange traded fund respectively.

Moreover, the overall depth and liquidity of the secondary market may also fluctuate. Therefore, value of the shares, when redeemed, may be worth more or less than their original cost. Due to market conditions, ETF shares trading on the exchange may be available for purchase at a premium or discount to NAV.

Principal Risk

An investment in an ETF structured as a mutual fund or unit investment trust involves the risk of losing money and should be considered as part of an overall program, not a complete investment program. An investment in ETFs involves additional risks: not diversified, the risks of price volatility, competitive industry pressure, international political and economic developments, possible trading halts, and index tracking errors.

Although ETFs are designed to provide investment results that generally correspond to the price and yield of their respective underlying indexes, the trusts may not be able to exactly replicate the performance of the indexes because of trust expenses and other factors.

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