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Are Exchange-Traded Funds Right for You?

As their numbers grow, we offer some basic factors to consider.

Let's take a refresher on exchange-traded funds (ETFs)--starting with their advantages and disadvantages. Hopefully, this exercise will give you the information you need to decide if ETFs might be a good fit for your portfolio.

Trading Flexibility
One key advantage that ETFs have over traditional mutual funds is trading flexibility. ETFs trade throughout the day, so you can buy and sell them when you want. However, the arbitrage mechanism that keeps the prices at which they trade in line with their NAV isn't fail-safe. Heavily traded issues such as SPDRs (which track the S&P 500) and QQQs (which track the Nasdaq 100) should trade right around the value of their underlying securities, but premiums and discounts could arise, especially for thinly traded funds.

Costs
In terms of the annual expenses charged to investors, ETFs are considerably less expensive than the vast majority of mutual funds. That's especially true when you get down to evaluating more specialized ETFs, which track less well known benchmarks.

That said, it's isn't as easy as comparing expense ratios. That's because you must pay commissions to buy and sell ETFs, just as you would for stock transactions. Thus, if you plan on making a single, lump-sum investment, then it may pay to choose an ETF. That said, if you invest regular sums of money, you'll actually end up costing yourself far more with an ETF than you would with many mutual funds.

Taxes
With a regular mutual fund, investor selling can force managers to sell stocks in order to meet redemptions, which can result in taxable capital-gains distributions being paid to shareholders. In contrast, most trading in ETFs takes place among shareholders, shielding the fund from any need to sell stocks to meet redemptions. Furthermore, redemptions made by large investors are paid in kind, again protecting shareholders from taxable events. All of this should make ETFs more tax-efficient than most mutual funds, and they may therefore hold a special attraction for investors in taxable accounts. Keep in mind, however, that ETFs can and do make capital-gains distributions, as they must still buy and sell stocks to adjust for changes to their underlying benchmarks.

Performance
Because they are shielded from investor trading, ETFs shouldn't suffer from having to keep cash on hand to meet redemptions, or from being forced to sell stocks into a declining market for the same purpose. That said, not all index funds are created equal. For example, despite competition from the ETF-set, Vanguard remains the firm to beat for indexing fans.

Conclusion
ETFs have a lot to offer. They're flexible and low-cost, and their underlying portfolios are protected from the impact of investor trading, making them more tax-efficient than most mutual funds. There are also ETFs that address specific subsectors that regular mutual funds do not.

Nevertheless, look carefully before you leap. ETFs' cost advantage isn't always as large as it might seem, and trading costs can quickly add up. Particularly if you're in the market for a fund that tracks a broad index such as the S&P 500, or if you wish to invest regular sums of money, make a careful comparison among the fund and ETF options.

A version of this article appeared October 25, 2000.

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