NEW YORK (Money) -- I recently saw an investment expert say that ETFs "defy every single principle of classic indexing." As this person saw it, the problem is that ETFs encourage frequent trading. But even if that's the case, do I have to worry about other investors' trading in ETFs if I'm a buy-and-hold investor? Or can their trading go on without affecting my returns?

- Ed Allwein, Denver, Colorado

Before I get to the nitty gritty of your question, let's first go over ETF basics.

Basically, an ETF is a type of index fund in that it holds all or nearly all of the stocks or bonds that make up a standard market benchmark.

That benchmark could be something very broad, like the Standard & Poor's 500 index. Or it could be a much narrower index, say, one that tracks small growth stocks or the energy sector.

Like index funds, ETFs also tend to have very low annual expenses.

But ETFs differ from index funds in a crucial way. Whenever you invest in a regular index fund, the manager has to accept cash and buy more stocks (or sell shares for cash to pay you if you're redeeming shares). That trading can boost transaction costs and hurt performance.

ETFs, however, trade on an exchange just like stocks. So when you buy or sell ETFs, you're buying or selling shares from another investor - the manager doesn't have to trade.

There are times when ETFs must create new shares or redeem shareholders outside the exchange system. But even then ETFs have a unique system absorbs costs. (For more on how ETFs operate, click here.)

As a result of their unique design, rapid trading in and out of ETFs on the part of some people doesn't jack up transaction costs for more conservative investors. This design also has some tax advantages that result in ETFs generally being a bit more tax-efficient than regular index funds. As a practical matter, however, the size of this advantage can vary greatly and I don't think it should be a deciding factor for most individual investors.

So the answer to your question is, no, you don't have to worry about the trading of other investors if you're staying in the ETF for the long haul. I should add, however, that your own trading costs are something you should consider when deciding whether to go with a regular index fund or an ETF. Every time you buy or sell an ETF you incur a brokerage commission. If you're investing small amounts, that brokerage fee can wipe out an ETF's cost advantage.

For example, if you invest, say, $500 a month in an ETF and pay a $10 brokerage commission each time, you need a 2 percent return just to recoup that commission, never mind the annual cost of holding the ETF and the brokerage fee you'll pay when you eventually sell. For this reason, you should probably consider ETFs only if you're investing substantial sums of money. For smaller investments and dollar-cost-averaging, regular index funds are a better bet.

As to that investment experts' warning about ETFs defying the principles of classic indexing, I'm pretty much on the same page.

I think indexing is most effective when you invest in indexes that track very broad swaths of the market. By buying, say, the entire stock market through a total stock market ETF or the entire bond market through a total bond market ETF, you get broad diversification at very low cost.

But these days ETF purveyors are slicing and dicing the market into ever-smaller shares. You can buy a sector, like tech stocks, or even narrower slices of a sector, like biotech or software.

One new "sector rotation" ETF will even move in and out of different sectors for you. That's great if you really think it's possible to know the right time for getting in and out of different sectors, or if you want to use these smaller niches to custom build a portfolio.

I have my doubts about how many investors (or ETFs, for that matter) can effectively time sectors and about how many people are up to building a portfolio using small specialized building blocks like subsectors. I guess I've seen too many investors get burned in the past jumping into hot industries and sectors just in time to see the sector go down in flames.

That said, however, there are some ways that smart investors can use ETFs to their advantage. If you'd like to find out about a few them, I suggest you check out this MONEY magazine feature story I wrote on ETFs earlier this year. And while you're at it, you might want to see which ETFs we at MONEY decided to include in our MONEY 65.

Just remember, though, when you come right down to it, an ETF is a tool. Use it wisely and it can help improve your investing strategy. Use it foolishly and you'll end up doing more damage than good.

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