Exchange Traded Funds (ETFs) are a versatile alternative to stocks and mutual funds. ETFs trade like a stock, but are composed of a group of stocks much like a mutual fund.  Companies that sell ETFs hold large blocks of stocks, then break them down into smaller units.  These smaller units are placed together in batches that form shares of an ETF.  ETFs are comprised of stocks of an index or industry sector.

Although still overshadowed by the more than $9 trillion in mutual fund assets, ETFs continue to attract investor money away from the mutual fund treasure trove. ETFs behave more like a mutual fund, and trend more smoothly than stocks. Since ETFs represent a batch of stocks, any one stock that drops in price will not dramatically effect the price of the ETF.

ETFs trade like a stock.  That means you can enter and exit an EFT anytime during the day.  You can’t do that with a mutual fund.  ETFs can be traded long-term or short-term and some have options.  ETFs can usually be traded in odd lots; you can trade as little as one share, making them available to all investors regardless of their account balance.

Most people who trade ETFs focus on the familiar QQQQ that tracks the NASDAQ 100 stocks.  But there are many ETFs available for trading, sold under the names of Holders, SPDRS, iShares, and Vipers.  For instance, Holders are sold by Merrill-Lynch and represent seventeen sectors.  You can buy semiconductors (SMH) or financials (XLF).  A unique feature of Holders is the ability to redeem ETF shares for shares of the actual stocks in the fund. There are ETFs that represent every sector and some pay a dividend.

There are more than 898 ETFs, and still growing. The SPY, based on the Standard & Poor's 500 index, is the largest ETF in terms of assets and one of the most actively traded.
      You can trade ETFs any time during market hours. They have no minimum investment other than buying a single share, and there are no penalties for redeeming. ETFs are more tax-efficient than mutual funds (less capital gains), and also have lower management fees.  However, you still pay a commission to trade ETFs. 

No one should consider ETFs without first understanding them.

A significant shift is under way, with new ETFs (and now ETNs) diverging from the original concept of replicating broad market indexes and providing diversification. Instead, they're emphasizing narrow industries, single countries or commodities.
      Oil, gold, medical devices, aerospace, insurance, home construction and biotech are typical of these specialized ETFs now available. This year, the Securities and Exchange Commission is likely to decide whether to approve ETFs with derivatives, options and debt securities, as well as actively managed ETFs that abandon the indexes altogether. ETFs are a tool, not a strategy. Be sure to fully understand the goal of your investment so that you use the correct tool.