Another plus of the ETF 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.
Yet, no investment vehicle is without its weaknesses.
Anytime you trade an ETF, notes Morris, you pay a brokerage commission, making them 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 also become a pitfall for some investors. "Unfortunately that encourages investors' worst instincts -- to chase past performance," says Morris.
Despite their growing popularity, ETFs remain largely unavailable to investors through 401(k)s and other employee-sponsored retirement plans, which often restrict their offerings to mutual funds.
Characteristics of index funds and exchange-traded funds
|
| Generates taxable distributions beyond investors' control | Yes | No |
| Offers broad diversification | Yes | Yes |
| Low expense ratio | Depends | Yes |
| Triggers brokerage commissions | No | Yes |
| Allows intraday trading | No | Yes |
| Can be bought on margin or sold short | No | Yes |
| Appropriate for dollar cost averaging | Yes | No |
| Allows reinvestment of distributions | Yes | No |
Those considering new investments for their personal portfolio, however, should weigh the pros and cons of ETFs and mutual funds against their need for tax efficiency and flexibility.