ETFs

What are Exchange Traded Funds (ETFs)?

ETFs - Similar to Index Mutual Funds, but Not.

What is an ETF? In short, they are similar to index mutual funds, but are traded more like a stock. As their name implies, Exchange Traded Funds (ETFs) represent a basket of securities that are traded on an exchange. As with all investment products, exchange traded funds have their share of advantages and disadvantages.

Advantages of Exchange Traded Funds

Being similar to stocks, exchange traded funds offer more flexibility than your typical mutual fund.

ETFs can be bought and sold throughout the trading day, allowing for intraday trading - which is rare with mutual funds.

Traders have the ability to short or buy ETFs on margin.

Low annual expenses rival the cheapest mutual funds.

Tax efficiency - due to SEC regulations, ETF tend to beat out mutual funds when it comes to tax efficiency (if it is a non-taxable account then they are equal).
Disadvantages of ETFs

Unfortunately, exchange traded funds do have some negatives:
Commissions - like stocks, trading exchange traded funds will cost you.

Only institutions and the extremely wealthy can deal directly with the ETF companies (must buy through a broker).

Unlike mutual funds, ETFs don't necessarily trade at the net asset values of their underlying holdings, meaning an ETF could potentially trade above or below the value of the underlying portfolios.

Slippage - as with stocks, there is a bid-ask spread, meaning you might buy the ETF for 15 1/8 but can only sell it for 15 (which is basically a hidden charge).
The Bottom Line

After comparing the advantages and disadvantages to using ETFs, you might conclude that they are a better deal than mutual funds - not true. Commissions make ETFs unattractive. If your portfolio is a tax deferred investment, like a 401(k) or an IRA, then you can avoid paying commissions by investing directly with a mutual fund company. Even in a taxable account, commissions make exchange traded funds look bad.

Morningstar provides a great example: a lump-sum investment of $10,000 in the iShares S&P 500 Index, with a very low trading cost of $8, would need to be held for two years to beat out the Vanguard 500 Index's costs. If you are investing less than $10,000 and are paying more than $8 commissions, or you are investing more than once, this example would make ETFs look much worse.

Investing directly with a mutual fund company generally beats out ETFs, especially in these situations:

Non-taxable accounts

Small investments - if you invest a certain amount each month or are on some sort of automatic investment plan (ETF commissions would kill your investment).

Active traders - although ETFs are primarily geared towards active traders, an active trader might be better off with mutual funds which don't charge commissions (most mutual funds discourage active trading, but some, like Rydex, Profunds and Potomac Funds encourage it).
Index Funds Outperform

Over the long term, the S&P 500 beats the returns of 80% of actively managed funds (and that isn't even taking into account tax efficiency).