In my previous newsletters I have talked about exchange-traded funds to consider adding to your portfolio, but I decided to take a step back and explain what they are and the benefits and drawbacks.

Definition
An exchange-traded fund is like a mutual fund since it is a basket of securities. However, these funds are traded on a stock exchange such as the American or New York Stock Exchange. The objective of these funds is to match the returns of a particular index such as the S&P 500 or NASDAQ 100.

Advantages
Trading Flexibility
Exchange traded funds trade like stocks. They can be bought and sold throughout the trading day, unlike mutual funds, which can only be purchased at the end of the day. You can place a stop loss on your trade, an order given to a broker to limit losses. You can even short an ETF if you feel the price is going down or use margin, which is using borrowed funds to purchase securities.

Lower Fees
According to the Investment Company Institute, expense ratios, which are the fees to cover the costs of running a mutual fund, on stock and bond mutual funds, averaged 1.13% and 0.9%, respectively in 2005. Fees on exchange traded funds average 0.42%, according to Schaeffer Research. However, several specialty ETFs have fees exceeding the industry average.

Variety
There are over 200 ETFs traded in the United States covering narrow industries like homebuilders or bank stocks as well as broader ones such as the Wilshire 5000 Index. Investors can gain exposure to US and international stocks, real estate investment trusts, bonds, commodities and currencies.

No Minimum Investment

Most mutual fund companies require a minimum investment, which can be as low as 500 or exceed 25,000 in some case. ETFs don’t have this restriction. If you want to buy 1 share of an ETF in your brokerage account you could, as long as you have the funds in your account to cover the transaction and brokerage commission.

Disclosure of Holdings
There is never a question about what securities are owned in an exchange traded fund because you can go to www.amex.com and check the holding on a daily basis. Mutual fund companies report holdings information less frequent, so you really don’t know exactly what you are investing in unless it is an index fund.

Disadvantages

Limits upside

If you pick individual stocks you could potentially make more money than buying exchange-traded funds, if you are right. Since ETFs are a basket of stocks, there may be a few companies dragging performance down that can put a cap on your upside potential.

Broker Commissions

ETFs are bought through a broker so you will have to pay a commission charge each time you buy or sell. If you deal with a discount broker commissions may be as low as 5 dollars, but full service brokers be 50 dollars or more for each trade.

Summary

ETFs are a great way for the everyday investor to create a diversified portfolio with a small amount of money, but it’s not for everyone. Be sure to do your homework to see if they make sense for your situation.

Some of the bigger families of exchange traded funds include:

iShares: www.ishares.com
Powershares: www.powershares.com
Select SPDR: www.spdrindex.com


Patrick Lyons is author of Map Your Financial Future: Starting the Right Path in Your Teens and Twenties. Order your autographed copy at www.MapYourFinancialFuture.com.