NEW YORK (CNN/Money) -
By combining the low-cost and diversification of index funds with the tax efficiency and flexibility of investing in stocks, exchange-traded funds can give individual investors more control over their portfolios, and even a shot at better overall performance.
Like any tool, however, ETFs aren't appropriate for everyone in every situation. Here is a rundown of the pros and cons:
Flexibility One of the most commonly cited is flexibility. Since ETFs are listed on an exchange, you can buy and sell them at whatever price they happen to be trading at during the day just as with stocks.
Mutual funds, by contrast, are priced only once, at the end of the trading each day.
And because ETFs trade like stocks, you can also buy on margin -- that is, buy shares with borrowed money in hopes of magnifying your gains -- and use techniques for profiting from market downturns such as selling short, which involves borrowing shares and selling them in the hopes of replacing them with less expensive shares when the market falls.
Low costs ETFs' biggest plus is their low annual operating costs. Their expenses are not only well below those of traditional mutual funds, but in many cases even less than the expenses levied by their index fund counterparts.
For example, the iShares S&P 500 ETF charges 0.09 percent of assets per year, or just $18 a year on a $20,000 investment, while the Vanguard Total Stock Market VIPER, an ETF that tracks the entire U.S. stock market including stocks large and small, carries annual operating fees of just 0.07 percent of assets, or just $14 a year on a $20,000 investment.
Tax efficiency When a mutual fund manager sells a stock for a gain, shareholders in the fund are on the hook, regardless of whether they've sold their fund shares.
Since ETFs trade on an exchange like stocks, however, you're usually buying shares from or selling them to another ETF investor. So the ETF itself doesn't have to buy or sell securities. Which means there aren't taxable gains to be passed on. (ETFs may still generate taxable gains, however, if they have to sell shares to reflect a change in the stocks that make up the index they track. And like any other mutual fund, an ETF must pass along interest and dividend payments it receives.)
Brokerage commissions Probably the biggest disadvantage to ETFs is that you've got to buy them through a broker.
Even with the low fees available at discount and online brokers these days, brokerage commissions can seriously erode ETFs' low-expense advantage, especially when investing small sums of money.
For example, if you were planning to invest, say, $100 a month in ETFs, even a cost of just $10 per trade would mean 10 percent of your investment is being siphoned off. So your ETFs' price would have to rise 10 percent just to recoup your buying cost -- and you'll have to pay a commission when you sell too.
For this reason alone, ETFs are generally better suited for investors who are socking away larger amounts of money -- as in 401(k) and IRA rollovers. If you're more likely to be dollar-cost-averaging with small sums or you tend to invest sporadically with modest amounts of money, you're probably better off in a regular mutual fund.
Too much flexibility? The ability to move in and out of ETFs quickly could easily lead to the temptation to try jumping into sectors of the market you believe are about to explode for gains and then bailing out just before the sector tanks.
In theory, that may be a great strategy. In reality, it's a difficult feat to pull off.
Many investors end up buying into hot sectors late after prices have been bid up and then find themselves selling for a loss after the sector flames out. Even if you manage to time your entry and exit correctly, there's still the matter of transaction costs, which can eat into potential returns.
You may be the shining exception, but research by University of California at Davis finance professor Terrance Odean shows that the more often individual investors trade, the worse they tend to do.
What are ETFs?
The perfect ETF portfolio