Old dog, new tricks

December 1, 2006

ETFs can actually be traded on an intraday basis, impossible with most conventional funds.

Back in your parent's time, there were far fewer investment options vying for attention. These days, new investment opportunities are popping up almost daily.

Among the newest being promoted by many brokerage firms are exchange-traded funds (ETF). Some brokers are saying that ETFs are a better deal than conventional mutual funds. If you believe, as I do, that mutual funds are a better choice than individual stocks for the typical investor, ETFs may sound very tempting to you. However, like most investment options, ETFs are complex; they deserve a close look before you jump in.

Exchange-traded funds are structured much like regular mutual funds, primarily index funds, with one important difference: They trade daily on the open market like stocks.

While ETFs are thought to be new by many investors, they actually have been around since 1993 when Standard & Poor's first created depository receipts, commonly known as "spiders." Later during the bull market of the '90s, many investors were attracted to the new investment option.

From a simple beginning, ETFs have proliferated to the point where you can find specialized versions that exclusively invest in tiny market segments, such as home building, technology, the markets of individual foreign countries, drugs and almost any niche you can think of.

The fact that ETFs can be traded daily, even minute to minute, separates them from traditional mutuals in a number of important ways. Depending on your investment philosophy, objectives and personal style, ETFs may or may not be a better choice for you. Here are some of the more important pros and cons:

On the plus side

ETFs can actually be traded on an intraday basis, impossible with most conventional funds.

The other side of the coin

The biggest drawback of ETFs for most investors is that they must be purchased through a broker.

Only institutions and the very wealthy can deal directly with ETF companies. This wouldn't necessarily be a problem for an investor who wants to make a large, one-time purchase of an ETF such as you might have with an IRA rollover, since you can accomplish that with the payment of a single commission.

For most people, likely to make their purchases in relatively small chunks over an extended period, this would mean a commission with each small purchase.

Even if you deal with one of the discount brokers, ETFs would be a bad choice if you practice dollar-cost averaging by making monthly or quarterly purchases on a regular basis.

Other drawbacks include: