ETFs combine the features of an index mutual fund with the advantages of trading individual stocks, at a very low cost. ETFs are similar to mutual funds, or at least index mutual funds. They represent a sector, style, or a way to invest internationally.

There is an exception to the linking of ETFs to various indexes and sectors. Merrill Lynch offers HOLDRs, which is a group of selected stocks focusing on a concept or industry, such as biotech. Most HOLDRs are based on a group of 20 stocks, and the original selection of stocks does not change. They are not subject to diversification rules. These funds must be purchased in 100-share increments.

ETFs are being touted as providing three advantages when compared to mutual funds: Tradability, tax efficiency, and lower costs.

Let's consider each of the three.

Tradability

Clearly, ETFs offer some advantages relative to mutual funds when it comes to how they can be bought and sold. A mutual fund (as opposed to a closed-end fund) has to be purchased from the investment company and sold back to the company. Therefore, if you own Fidelity's Equity-Income Fund, which you bought from Fidelity, you must contact Fidelity and instruct them to redeem the shares when you are ready to sell.

The pricing of mutual funds occurs once a day, at 4 p.m. when the markets close. If an investor desperately wishes to liquidate a mutual fund position at 10 in the morning, he or she is out of luck. The market may decline 500 points between 10 a.m. and 4 p.m., but there is nothing you can do. Conversely, the market may rise 500 points in that time, but you can't buy into the fund at that point.

It is also clearly the case that investors can buy ETFs on margin, thereby magnifying their potential gains. Of course, the potential losses are also magnified. Regardless, this cannot be done with mutual funds.

A significant advantage of ETFs is that they can be sold short if an investor anticipates a decline in the market or a particular sector. A short sale is a bet that the market price will decline. Just as investors buy funds if they expect the market to go up, some investors would like to be able to short funds when they expect the market to decline.

Because ETFs are, in effect, like any other stock, they can be sold short. In contrast, if you are strictly a mutual fund investor, it will be difficult to invest on the basis of a predicted market decline. A few funds cater to such a strategy, but they are relatively rare.

Tax Efficiency

As we have seen, mutual funds have a potentially large disadvantage when it comes to taxable distributions. The investor has no control over what the fund will distribute in a particular year, and therefore can face a large tax bill on the distributions. The year 2000 is now famous, or infamous, for just such events. Many mutual fund managers took some gains early in the year following the great market years of the late 1990s, and then when the market declined and the funds had to sell shares to pay redeeming shareholders, still more taxable distributions were realized.

ETF investors are protected, but perhaps not as much as many assume. They definitely are protected from redemption gains. Mutual funds, including index funds, are vulnerable to investors leaving the fund in sufficient numbers that the fund manager must sell portfolio positions to buy back shares of departing investors. Because of the unique redemption feature of ETFs, they are able to avoid such transactions.

However, ETFs are not protected when sales of positions in the portfolio must be made as a result of changes in the associated index, or even by diversification issues. This is quite possible with a smaller fund where rebalancing needs can arise fairly often. Think of an ETF invested in shares of a small foreign country, and holding perhaps 30 or 40 stocks. Should one of these stocks appreciate substantially, the manager might feel compelled to reduce the size of the holdings of this strongly performing stock, thereby generating a taxable distribution.

Regardless of the cases just mentioned, many of the well-known ETFs are very tax efficient. Let's compare Vanguard's 500 Index Trust (one of the two largest mutual funds in the United States) with the S&P 500 Spider. Both are based on the S&P 500 Index, an extremely popular and well-known measure of the stock market.

For the years 1997 through 2001, the capital gains distributions for the Vanguard 500 Index Trust were $2.01, compared with nothing for the S&P 500 Spider. Clearly, ETFs can be tax efficient when it comes to capital gains distributions.

Costs

ETFs are known for their low costs. The Vanguard 500 Index Trust previously discussed is known as a superefficient index fund in terms of costs, with an annual expense ratio of 0.18 percent. For index mutual funds, it doesn't get any lower than this. The S&P 500 iShare ETF tops Vanguard's low cost with a really startling figure—0.09 percent on an annual basis. It is difficult to imagine how costs could go any lower.

The cost issue might or might not be as important as it first appears. For all practical purposes, the operating cost difference between the Vanguard index fund and the ETF illustrated is not very large. The reason the costs for both are low, of course, is that both are unmanaged portfolios, and therefore costs are not generated for security analysis. As we start to examine actively managed mutual funds, of course, the expenses become much higher, and make a much more significant difference.

ETFs are not for all investors. Regular purchases incur ongoing brokerage fees. Trading ETFs on a short-term basis leads to short-term capital gains taxed at the highest marginal rates.