Exchange-traded funds (or ETFs) are a type of mutual fund. Essentially, ETFs are mutual funds that trade on the stock market. As such, they offer features of a mutual fund in a stock-like instrument.
Just like mutual funds, ETFs represent a collection of underlying securities or stocks. Typically, ETFs try to replicate an index such as the S&P 500, Dow Jones Industrial Average (DJIA), Russell 2000, MSCI EAFE, and so on. Presently, nearly all ETFs are passively managed. That is, unlike many mutual funds, the firm managing the ETF does not actively add or remove stocks (unless the index being tracked changes). The first, and most widely held (as of November 2004) ETF is the S&P 500 "Spider" (SPY) - the nickname is a pronunciation of the fund's acronym, SPDR, which stands for Standard and Poor's Depositary Receipt. Also popular and well known are the "qube" (QQQQ), which tracks the NASDAQ 100 Index, and the "Diamond" (DIA), which tracks the Dow Jones Industrial Average.
There are over one hundred ETFs traded on U.S. stock exchanges, with more in other countries. ETFs have been gaining popularity ever since they were introduced in the mid 1990s, beginning with SPY in 1993. ETFs are attractive to investors because they offer the diversification of mutual funds with the features of a stock. The popularity is likely to increase as new and more innovative ETFs are introduced.
Today ETFs present a viable alternative investment option from index funds and mutual funds. There are many available ETFs that resemble all kind of indexes (such as large-cap, mid-cap, small-cap, etc), specialties (such as value and growth), industries, countries, and even commodities (while commodity funds like Gold Shares are technically not ETFs, they trade like ETFs). And more are being developed for the future. There are discussions of ETFs for other indices and commodities, as well as actively managed ETFs.
Since ETFs evolved from the concept of index funds, they typically have very low expense ratios compared to actively managed mutual funds. They also have lower turnover ratio, which is more tax-favorable.