4. Exchange-Traded Funds (ETFs) How they work: As their name suggests, ETFs have qualities of both stocks and funds. Though they're composed of a basket of securities, they're traded like a stock, so prices vary throughout the day. (Mutual funds are priced once daily.) But like mutual funds, ETFs can be composed of a pool of equities, bonds, commodities, currencies, derivatives, etc. ETFs are generally designed to mirror indexes, but that's not always so. Some new products, like Invesco PowerShares' line of Active ETFs, which came on the market in mid-April, are actively managed.
Demand for ETFs is fueling rapid growth in their offerings. It's possible for inflation-leery individuals to find ETFs invested in high-growth stocks or dividend-rich equities.
Price: Varies throughout the day. Commissions are charged with purchases and sales.
Liquidity: Very liquid. You can trade ETFs as frequently as you want, just as with stocks. You can place limit orders on them, short them, buy them on margin.
Pros: Low management costs and rich yields. Because most ETFs are not actively run by a manager, ETFs are generally cheaper than a mutual fund. For example, a typical large-blend stock ETF costs 0.50 percent vs. 0.86 percent for the typical large-blend mutual fund, according to Lipper. A government bond ETF (including TIPS) generally costs 0.15 percent vs. 0.65 percent for the typical government bond mutual fund.
"They often have just half the ongoing costs of a mutual fund that holds similar assets," says Jeff Tjornehoj, senior research analyst at Lipper.
Tax efficiency: There are two reasons ETFs are generally tax efficient. Generally, underlying assets in an ETF are pegged to an index, so they're not traded as frequently as an actively managed mutual fund. And ETFs usually don't make large capital gain distributions to investors either, keeping taxes in check.
"When market makers are creating and redeeming ETF shares, they can swap out low-cost basis shares of stock and, in so doing, lower the likelihood the fund will incur large capital gains," explains Jeffrey Ptak, director of exchange-traded securities analysis at Morningstar. "Mutual fund managers don't have the same mechanism to ensure minimal capital gains are passed to investors."
Because there are hundreds to choose from, you can buy an ETF to suit your needs, be it a need to load up on high-growth stocks, dividend-paying value equities, inflation-proof TIPS or tax-friendly municipal bonds. Investors looking for a variety of dividend-paying stocks, for example, may consider Vanguard High Dividend Yield or WisdomTree Total Dividend ETFs.
Con: Transaction fees. Investors must pay commissions every time they trade an ETF, so they can wind up being pricey for active traders. And dividends that are reinvested in an ETF can be subject to brokerage commissions, too.
Risks: An ETF's market price may skew widely from its net asset value. Though it's uncommon, investors need to be aware this "adds a certain level of uncertainty," says Ptak.
ETFs are often made up of a pool of assets in a narrowly defined index or in a particular sector. That concentration can increase the risk for price declines more than actively managed funds, which tend to have more diversification, says Christine Benz at Morningstar.
Who they're good for: Relatively low management costs and tax efficiency make ETFs better for budget-minded retirees who are looking to invest a sum of money for years instead of weeks or months, and who may be seeking to diversify assets. They also offer a convenient, no-fuss alternative to individual securities since it's "relatively easy to pick one off the shelf and plug it into a portfolio," says Ptak.