Exchange-traded funds have enjoyed a rapidly growing popularity throughout the investing public, except among one key group: investors who are wary of the risks associated with equity investments.

Because the universe of exchange-traded funds, or ETFs, is expanding, several new bond-based ETFs have come on the market. At the end of 2008, there were 60 ETFs tracking bond indexes, up from six in 2006.1

If you avoided ETFs because they were predominantly composed of stocks, the growing availability of bond ETFs might warrant a second look.

Bonding with the Stock Exchange
An ETF is a portfolio of securities that is assembled by an investment company and sold in shares that trade like stock. The investment company holds the underlying securities in trust and sells ownership of them in shares. The underlying securities typically track an index, a sector, or a group of securities that share a common thread.

The value of an ETF share may be only loosely related to the value of the underlying securities. Supply and demand for the shares themselves may cause them to trade at a premium or a discount relative to the value of the underlying shares, although their prices tend to track the underlying value most of the time. ETFs are subject to investment risk and their value will fluctuate with changes in market conditions. Shares, when sold, may be worth more or less than their original cost.

Why not just buy the underlying securities? ETFs enable investors to target almost any index, sector, country, or other specific market segment and still achieve a level of diversification that might be cost-prohibitive for some individual investors to achieve. This is especially true of bonds, which typically carry face values in multiples of $1,000. This ability to be selective can help investors structure portfolios that better fit their style allocations. Bond ETFs are subject to the same inflation, interest-rate, and credit risks associated with their underlying bonds.

Why an ETF instead of a traditional mutual fund? Depending on your situation, ETFs may not be able to replace the role that mutual funds may play in your portfolio, but they can serve a complementary role. ETFs are passively managed, which means they don’t have a professional manager who can respond to changing conditions. ETFs tend to offer lower expense ratios and greater tax efficiency. There are no sales loads or minimum investment amounts. However, investors typically need a broker to buy ETFs and therefore must pay a commission. Investing in ETFs should be based on an investor’s goals, time horizon, and risk tolerance. Past performance is no guarantee of future results.

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