The Lowdown on Exchange Traded Funds

Question of the week:I've been hearing a lot lately about exchange traded funds. What can you tell me about this new-fangled investment? --LBK

Dear LBK,

Exchange traded funds (ETFs) combine some of the best advantages of index mutual funds with the flexibility of stocks. Like an index fund, each ETF tracks the securities of a particular equity or bond index. However, like a stock, ETFs are bought and sold throughout each trading day, and can be sold short or bought on margin. Perhaps the best known ETFs include SPDRs (often called "spiders"), which track the S&P 500, and DIAMONDS, which track the Dow Jones Industrials.

We recently asked members of the Armchair Millionaire community about why they invest in ETFs. Here are some of the responses we received:

"I invest in ETFs for their convenience and low cost. With just three different ETFs, I get a simple, yet diversified portfolio that requires no attention from me." --Jeffrey T.

"ETFs are wonderful in this type of market. If you choose carefully and perform due diligence you can obtain ETFs that provide quality monthly distributions with the potential for capital gain. Some even have managed distribution programs that guarantee a distribution." --Keith

For people like me who are big believers in the benefits of passive investing, there is a lot to like about ETFs, and very little to dislike. My checklist provides a roundup of benefits of ETF investing.

The Armchair Millionaire Checklist of ETF Advantages

• Instant diversification. Because there are a large number of stocks or bonds underlying every EFT, a single purchase gives you terrific diversification.

• Choice. There are now over one hundred exchange traded funds available, covering everything from the broadest market indexes, such as the S&P 500, to some fairly narrow industry sectors. This wide array makes it easy to implement an asset allocation strategy that's just right for your time horizon and risk tolerance.

• Tax efficiency. Because they are not actively managed and have very little portfolio turnover, ETFs carry some nice tax advantages, distributing relatively few capital gains.

• Low expenses. Like index funds, most ETFs have very low management fees. ETFs that track industry sectors or international indexes tend to have somewhat higher expenses.

One caveat: Since all ETFs must be bought and sold through a broker, you incur a commission cost every time you trade, making it expensive to buy small amounts. This means that ETFs are usually not the best choice for use in dollar cost averaging where you are investing small sums on a regular basis. One way to sidestep this cost is to invest through Sharebuilder.com or Buyandhold.com, two online services that allow you to make regular ETF investments for just a couple of dollars per transaction.

THE BOTTOM LINE: As new investment products continue to evolve, it's important to keep current with which ones offer the best benefits to common sense, long-term investors. Exchange traded funds are a good alternative to mutual fund for making lump sum investments and are well worth a closer look.