Exchange-Traded Funds: Do They Belong in Your Portfolio?

Exchange-traded funds (ETFs) have become increasingly popular since they were introduced in the United States in the mid-1990s. Their tax efficiencies and relatively low investing costs have attracted investors who like the idea of combining the diversification of mutual funds with the trading flexibility of stocks. ETFs can fill a unique role in your portfolio, but you need to understand just how they work and the differences among the dizzying variety of ETFs now available.

Like a mutual fund, an exchange-traded fund pools the money of many investors and purchases a group of securities. Like index mutual funds, most ETFs are passively managed. Instead of having a portfolio manager who uses his or her judgment to select specific stocks, bonds, or other securities to buy and sell, both index mutual funds and exchange-traded funds attempt to replicate the performance of a specific index.

However, a mutual fund is priced once a day, when the fund's net asset value is calculated after the market closes. If you buy after that, you will receive the next day's closing price. By contrast, an ETF is priced throughout the day and can be bought on margin or sold short--in other words, it's traded just as a stock is.

Since their inception, most ETFs have invested in stocks or bonds, buying the shares represented in a particular index. For example, an ETF might track the Nasdaq 100, the S&P 500, or a bond index. Other ETFs invest in hard assets--for example, gold bullion. In such cases, a commodity or precious-metals ETF may buy futures contracts or quantities of bullion. With the rapid proliferation of ETFs in recent years, if there's an index, there's a good chance there's an ETF that invests in it.

More and more new indexes are being introduced, many of which cover narrow niches of the market, or