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ETF Breakdown: Understanding the Three Categories

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Whether trading, traditional or niche, exchange-traded funds are great diversifiers.

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The exchange-traded fund (ETF) boom has been one of the fantastic bull-market trends of all time. Unfortunately, it's been one of those trends that we as investors haven't yet been able to cash in on, but have been able to directly participate in by learning the business and understanding the players.

I started using ETFs years ago and have slowly evolved to a separate managed account (SMA) model that utilizes them exclusively. But interestingly enough, you wouldn't believe the number of people with whom I discuss my SMA strategy who have never heard of an ETF. If you happen to be one of the few who don't yet understand just what an ETF is, in simple terms, it's a tracking stock that owns a basket of underlying securities. It allows you to diversify your holdings in the same manner as a mutual fund, but without the restrictions of buying and selling at 4 p.m., as ETFs trade when the market is open.

I believe one of the greatest strengths you can have as a trader is to know all the major ETFs intimately. When you see a sector or market moving, it's helpful to know exactly how to play it via ETFs, rather than searching this out when it's time. Being prepared is always worth more than you can ever imagine.

Observing this growing industry has been fascinating, and like old media versus new, I suspect it will still be several years before the dying, mutual-fund world, understands the competition that ended up cleaning its clock. Yet with this incredible market and unbelievable opportunity, I'm still not sure if all the players in the game understand their very own business and roadmap to success.

The key to the ETF business is assets under management - which is ultimately how the issuing company makes their money. However, in order to truly beef up these assets, the ETF has to first become popular enough to give it enough daily volume to actually make it something worth holding.

The ETF world grows every single week, but most ETFs will never land on your radar, as they'll be closed before ever receiving enough daily volume to make them a viable option for investors. These ETFs should simply all be given the symbol DOA, or Dead on Arrival.

In my opinion you can break down the ETF market into 3 categories: Traditional, Trading and Niche, 2 of which have been monopolized though the third is still up for grabs. This doesn't include your founding fathers, such as the Spiders S&P 500 Trust (SPY), or the PowerShares QQQQ Trust (QQQQ) - which have taken their place atop the ETF mountain, never to be replaced.

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