Ask Carrie by Carrie Schwab-Pomerantz

Dear Carrie: What's the difference between an exchange-traded fund and a mutual fund? — A Reader

Dear Reader: Good question! Although they aren't new, exchange-traded funds (ETFs) have proliferated in the last few years, and consequently they have gotten a lot of attention. I'm sure many people are struggling to understand exactly where ETFs fit into the investment landscape and — more importantly — when they make sense for their portfolios.

Virtually every investor knows that you can construct a portfolio with individual stocks and bonds or by buying mutual funds. And most investors know that mutual funds come in one of two basic flavors: actively managed funds, in which a team of investment professionals makes buy/sell decisions in an effort to outperform a market, and index funds, which aim to replicate the performance of a particular index.

Exchange-traded funds, on the other hand, are essentially index mutual funds that trade like stocks. Like a mutual fund, an ETF represents a basket of other securities. The key difference is that like a stock (and unlike mutual funds), you can buy or sell an ETF at any point during the trading day.

ETF FEATURES

You can find ETFs that track almost every conceivable market and market niche. Many of the traditional ETFs (for example SPY, which tracks the S&P 500) can fill the same role as index funds: providing a high degree of diversification at a fairly low cost. Other ETFs track individual sectors, such as health care, single countries or narrow parts of the bond market. And other more exotic ETFs track commodities, such as gold, or execute esoteric investment strategies.

As you consider investing in an ETF, realize that:

— You'll generally pay brokerage commissions on ETF trades — an especially important point for investors who trade frequently.

— ETFs generally have very low management fees as compared to actively managed funds — often even lower than index funds.

— Both ETFs and index funds tend to be tax-efficient, but capital gains distributions are even rarer for ETFs. Actively managed funds are usually the least tax-efficient.

WHEN ETF TRANSACTIONS MAKE SENSE

When would you choose an ETF?

— If you're looking for exposure to a specific asset class or a niche market, you'll probably find an ETF that meets your needs.

— If you're new to investing, ETFs can offer a quick, cost-effective way to diversify.

And if you're ready to invest a large amount, the commissions will be trivial as a percentage of your investment. (But investors who make frequent smaller investments will probably find index funds a cheaper solution.)

— Because of their tax-efficiency, ETFs are particularly well suited to taxable accounts.

— If you're an active or sophisticated trader, ETFs offer more flexible ways to execute portfolio strategies. Because they are traded like stocks, you can execute stop orders, limit orders, short sells and options on ETFs. Just be sure to think about commission costs.

WHEN ETF TRANSACTIONS DON'T MAKE SENSE

— A smaller investor. For example, someone who wants to invest a few hundred dollars a month to begin building a portfolio may be better off with a mutual fund. Even a discount brokerage commission on a small ETF transaction could be disproportionately expensive.

— If your goal is to outperform the market, an indexed approach, whether through an ETF or a traditional index fund, doesn't make sense. You'll want to consider actively managed funds.

WHAT TO WATCH OUT FOR

As I mentioned, ETFs tend to be diversified, but don't assume that all ETFs are safe. Among the hundreds of ETFs available today are niche products that focus on very narrow sectors, exotic ETFs that invest in esoteric strategies and instruments, leveraged ETFs that, as their name implies, are far more volatile than basic ETFs, and even "inverse ETFs" designed for contrarian investors. These may be good instruments for sophisticated investors, but they are not suitable for most buy-and-hold investors.

There is no question that ETFs represent a very useful instrument for a wide spectrum of investors. But as with any investment, be sure you know what you're buying and at what cost. With ETFs (ditto for any index fund), understand how the underlying index fits into your portfolio. Good luck!

Carrie Schwab-Pomerantz, CERTIFIED FINANCIAL PLANNER (tm) is president of the Charles Schwab Foundation and author of "It Pays to Talk." You can e-mail Carrie at askcarrie@schwab.com. This column is no substitute for an individualized recommendation, tax or personalized investment advice. To find out more about Carrie Schwab-Pomerantz and read features by other Creators Syndicate writers and cartoonists, visit the Creators Syndicate website at www.creators.com.

COPYRIGHT 2010 CHARLES SCHWAB & CO. INC. MEMBER SIPC

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