What You Need to Know About ETFs

Exchange-traded funds are easier to understand and use than their names suggest.

1. Don't be put off by the alphabet soup. Exchange-traded funds are easier to understand and use than their names suggest. Basically, ETFs are mutual funds that trade like stocks. Some copy the returns of broad stock- and bond-market indexes. Others replicate the performance of baskets of stocks in single industries or in niche investments, such as IPOs. For fact sheets on ETFs, visit www.amex.com, www.nyse.com or www.nasdaq.com. To compare funds by cost, use the Mutual Fund Expense Analyzer at www.nasd.com.

2. ETFs make a good entree or a tasty side dish. ETFs are great for building a portfolio that matches your investment style. For example, you can construct an aggressive portfolio made up solely of stock ETFs. Or if you prefer a balanced approach, you can mix stock and bond funds. You can also use ETFs as an inexpensive way to boost your exposure to, say, fast-growing companies or emerging markets. And if you own too many shares in a single industry, such as energy, you can even hedge your risk by selling short an ETF that focuses on that industry. (Learn about more-sophisticated designer" ETFs.)

3. Spiders and Vipers are your friends. Standard & Poor's depositary receipts are nicknamed Spiders, and they track a variety of SP indexes. For example, SPDR Trust, Series 1 (SPY), tracks the SP 500-stock index. Vipers are separate share classes of Vanguard's index funds and offer nearly identical returns. For instance, Vanguard Total Stock Market Vipers (VTI), like Vanguard Total Stock Market Index fund, tracks the MSCI U.S. Broad Market index. Spiders and Vipers generally have lower management expenses than comparable funds, and over time, lower expenses boost returns.

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4. Invest regularly? You'll pay for it. Whenever you add to your ETF holdings, you'll pay a commission, ranging from $5 to $25 a trade, at the 11 online brokerages in our latest survey (see page 40). If you plan to invest in, say, biweekly installments or rebalance your portfolio frequently, consider using FolioFn, a firm that lets you make dozens of trades for a flat yearly fee, starting at $199 a year.

5. Obscure ETFs may be costly to trade. ETFs that focus on narrow sectors and industries are often lightly traded. Such relative unpopularity can lead to spreads as wide as 50 cents between the "bid price" a buyer is ready to pay and the "ask price" a seller is ready to accept. One solution: Use limit orders, which allow you to buy and sell at predetermined prices.

6. Taxes tarnish metals funds. When you sell shares in a typical ETF, your gains are taxed the same way as when you sell shares of stock -- and you enjoy the same maximum long-term capital-gains rate of 15%, as long as you hold the shares for more than a year. But ETFs that track the price of gold, such as StreetTracks Gold Trust (GLD) and iShares Comex Gold Trust (IAU), are an exception to the rule. The top long-term gains rate jumps to 28% because the IRS considers investments in gold ETFs equivalent to buying collectibles. If you hold a gold ETF for less than a year, your short-term gain will be taxed as ordinary income.