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ETFs, which track the performance of a stock or bond index, are much like index funds but with a bit more bling.

Offering broad market exposure, tax efficiency and lower operating costs, they are designed to pick up where mutual funds leave off.

"One of the chief benefits of the ETF is that they tend to be significantly cheaper than conventional mutual funds," says Sonya Morris, editor of Morningstar ETFInvestor, though some index funds offer competitive expense ratios, she adds.

ETFs are baskets of securities bought and sold on an exchange, not unlike individual securities.

Among the more popular ETFs are Spiders (SPY), so named because they track the Standard and Poor's 500 index of large-cap stocks. Diamonds (DIA), meanwhile, track the Dow Jones industrial average, while Cubes (QQQQ) follow the stocks held in the Nasdaq 100 index.

ETF prices fluctuate real-time throughout the day, making them well-suited for individual investors engaged in intraday trading.

They also can be bought on margin -- using borrowed money -- and sold short for those betting on a market slide.

Another plus of ETFs is that, because they don't have to sell underlying securities to meet redemptions, they rarely distribute taxable gains to shareholders. ETF investors sell shares to other investors.

ETF weakness
Anytime you trade an ETF, notes Morris, you pay a brokerage commission, making ETFs less attractive for active traders and anyone using a dollar-cost-average investment strategy (those who buy into a position with small, periodic investments over time).

At the same time, the flexibility to trade ETFs like stocks can become a pitfall for some investors. "Unfortunately, that encourages investors' worst instincts -- to chase past performance," Morris says.

Despite their growing popularity, ETFs remain largely unavailable to investors through 401(k)s and other employer-sponsored retirement plans, which often restrict their offerings to mutual funds.

However, those considering new investments for their personal portfolio should weigh the pros and cons of ETFs and mutual funds against their need for tax efficiency and flexibility.

Characteristics of index funds and exchange-traded funds
  Index mutual funds ETFs
Generates taxable distributions beyond investors' control
Offers broad diversification
Low expense ratio
Triggers brokerage commissions
Allows intraday trading
Can be bought on margin or sold short
Appropriate for dollar-cost averaging
Allows reinvestment of distributions
-- Posted: Nov. 10, 2008
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