Carrie Schwab Pomerantz

Dear Carrie: What's the difference between an exchange-traded fund and a mutual fund? -- A Reader

Dear Reader: Good question! Although they aren't new, exchange-traded funds (ETFs) have proliferated in the last few years, and consequently they have gotten a lot of attention. I'm sure many people are struggling to understand exactly where ETFs fit into the investment landscape and -- more importantly -- when they make sense for their portfolios.

Virtually every investor knows that you can construct a portfolio with individual stocks and bonds or by buying mutual funds. And most investors know that mutual funds come in one of two basic flavors: actively managed funds, in which a team of investment professionals makes buy/sell decisions in an effort to outperform a market, and index funds, which aim to replicate the performance of a particular index.

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Exchange-traded funds, on the other hand, are essentially index mutual funds that trade like stocks. Like a mutual fund, an ETF represents a basket of other securities. The key difference is that like a stock (and unlike mutual funds), you can buy or sell an ETF at any point during the trading day.

ETF FEATURES

You can find ETFs that track almost every conceivable market and market niche. Many of the traditional ETFs (for example SPY, which tracks the S&P 500) can fill the same role as index funds: providing a high degree of diversification at a fairly low cost. Other ETFs track individual sectors, such as health care, single countries or narrow parts of the bond market. And other more exotic ETFs track commodities, such as gold, or execute esoteric investment strategies.

As you consider investing in an ETF, realize that:

-- You'll generally pay brokerage commissions on ETF trades -- an especially important point for investors who trade frequently.

-- ETFs generally have very low management fees as compared to actively managed funds -- often even lower than index funds.

-- Both ETFs and index funds tend to be tax-efficient, but capital gains distributions are even rarer for ETFs. Actively managed funds are usually the least tax-efficient.

WHEN ETF TRANSACTIONS MAKE SENSE

When would you choose an ETF?

-- If you're looking for exposure to a specific asset class or a niche market, you'll probably find an ETF that meets your needs.


Carrie Schwab Pomerantz

Carrie Schwab Pomerantz is a Motley Fool contributor.

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