Rex: I have been reading a lot about “exchange-traded funds.” I do not understand how they differ from mutual funds. Can you explain the differences and benefits?

Elaine: Exchange-traded funds have become extremely popular in recent years because they’re considered to be a “cheap” way to gain exposure to a diverse array of asset classes such as domestic and international stocks, bonds and commodities. Exchange-traded funds are essentially index mutual funds that trade like stocks. ETFs are often seen as combining the best features of mutual funds and stocks into one package.

If you actively trade your investment, either with intraday trades, stop orders, limit orders, options or short selling, you should use an ETF, because these are not possible with a mutual fund. Or if you are looking for access to a niche of the market that isn’t covered by a mutual fund (such as a particular industry or commodity), an ETF may be a good tool for this.

ETFs are tax efficient and generally generate relatively low capital gains because they typically have low turnover of their portfolio securities.

The obvious costs for ETFs are the commissions paid to trade them and the management fees paid while they are held.

Commissions paid on ETFs work in a manner similar to the fees charged by a broker to execute stock trades. The more frequently you trade, the more you’ll pay in commissions. Because commissions are usually charged as a flat dollar amount, if you trade frequently or in small dollar amounts this could negatively impact the value of your portfolio.

According to Warren Brashear, Memphis branch manager for Charles Schwab & Co., “ETFs usually have attractively low management fees compared to actively managed mutual funds, and in some cases even when compared to passively managed index-based mutual funds.” ETF management fees are usually stated in terms of a fund’s operating expense ratio, which is expressed as an annual rate charged by the fund (not your broker) on the total assets held in the security. These operating expenses are primarily used by the fund to pay for things like portfolio management and administration costs.

While ETF commissions and management fees are easily understood, a third type of cost, the bid/ask spread, is more esoteric.

The “ask” or “offer” is the market price at which an ETF can be bought, and the “bid” is the market price at which the same ETF can be sold. The difference between these two prices is commonly known as the bid/ask spread and can be thought of as a transaction cost similar to commissions except that the spread is built into the market price and is paid on each round-trip purchase and sale. So, the larger the spread and the more frequently you trade, the more relevant this becomes to the value of your portfolio.

ETFs are not a good fit for every investor. Brashear adds, “If you are making small regular investments, such as a monthly or quarterly IRA deposit or a dollar-cost averaging strategy, the commissions from trading ETFs generally make them more expensive than a no-load, no-transaction-fee mutual fund.”

Questions? Write Elaine at Elainezimm@aol.com. Her Web site is elainezimmermann.com.

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