ETFs: Popular, Trendy, Hot ... And Worth Checking Out

Should this alternative to mutual funds be in your portfolio?

By Jordan Taylor

Exchange traded funds, commonly referred to as ETFs, were introduced in the early 1990s and have been gaining popularity ever since. What's the appeal?

First, let's define ETFs. They are index funds or trusts that are listed on an exchange and can be traded all day long just like regular stocks. The funds hold a pool of securities that are typically unified by a particular investing theme, such as biotech, healthcare, real estate, and utilities. If you are attracted to a particular industry or segment but don't want to commit your money to a particular company, ETFs are a great solution. ETFs have ticker symbols-and some are quite clever, such as Qubes (QQQQ), Spiders (SPY), and Diamonds (DIA)-and add the flexibility, ease, and liquidity of stock trading to the benefits of traditional index fund investing.

Here are some of the issues that make ETFs an attractive investment, especially as an alternative to mutual funds:

Tax efficiency. ETFs tend to generate fewer capital gains due to low turnover of the securities that comprise the portfolio. ETFs are not required to sell securities to meet investor cash redemptions, a move which could generate capital gains tax liability for the remaining investors. Instead, an investor who wants to liquidate ETF shares simply sells them to other investors and is personally responsible for taxes on the resulting capital gains or losses.

Lower costs. In general, ETFs have lower annual expense ratios than other investment products because they are index-based and not actively managed. You can use ETFs to create a diversified portfolio without sales loads, redemption fees, and other restrictions common to mutual funds. Annual fees for ETFs typically range from 0.1 to 0.65 percent, while index mutual funds charge anywhere from 0.1 to more than 3 percent. Of course, ordinary brokerage commissions apply to the purchase and sale of ETFs.

All day trading. Traditional open-end mutual funds take orders during Wall Street trading hours but the transactions actually occur at the close of the market. The price they receive is the sum of the closing day prices of all the stocks contained in the fund-a figure that could change substantially from the time you place a noon order and the market closes. By contrast, ETFs are priced and traded throughout the day, so you'll always know what price you are paying-or getting-for an ETF.

Choice and diversification. The inherent nature of an ETF is diversified because each fund is comprised of a basket of securities. The universe of ETFs is growing, with more than 200 funds covering almost every sector imaginable. Instead of depending on the wisdom (or lack thereof) of a mutual fund manager, you can be your own manager and make your own decisions about the sectors in which you invest.

Buying and selling flexibility. ETFs can be bought and sold at intraday market prices, purchased on margin, sold short, and traded using stop orders and limit orders. You can use ETFs to implement a wide array of investment strategies.

ETFs are purchased as you would any stock at any brokerage. While ETFs are not guaranteed or insured, their creation and trading is closely monitored by the U.S. Securities and Exchange Commission (SEC) and there appears to be limited risk in terms of the ETF structure. However, the underlying assets do carry risk, which will vary depending on the asset class and other circumstances and are similar to those of other diversified portfolios.

As with any investment, you should know what you're buying when you purchase ETF shares. Study the prospectus and make sure the ETF label matches the underlying securities you want to buy. And if you want to invest in ETFs, be sure that you are really buying ETFs and not a disguised mutual fund.

ETFs are a flexible, multi-purpose, and practical vehicle for investing in the stock market quickly and with reduced capital. In principle, they aren't any more complicated than their underlying securities. If you know enough to buy those, you know enough to buy ETFs. Whether you are an active stock trader or a buy-and-hold investor, ETFs are worth considering for your portfolio.