Are the mutual fund's days numbered?

(Money Magazine) -- Ever since exchange-traded funds were created in the early 1990s, they've been seen as a threat to old-fashioned mutual funds. That's because ETFs can offer you instant exposure to a wide range of investments -- from the broad stock and bond markets to individual sectors to niche strategies -- all with a single trade.

At the same time, they're not as likely to expose you to as big a tax hit as a traditional fund, and they're often a cheaper bet. The Vanguard Total Stock Market ETF, for instance, charges annual fees that are less than half of what its mutual fund sibling levies. To top it off, ETFs can be bought and sold throughout the trading day, just as stocks can. Traditional funds can be bought or sold only once daily at the closing price.

Yet despite these advantages, ETFs have always come with a major drawback. For as long as they've been around, you've had to pay commissions to a brokerage anytime you bought or sold these shares. So if you invest small amounts monthly, those charges could swamp the other cost advantages of an ETF.

But that's starting to change. In May, Vanguard said it would lift commissions on trades for all 46 of the ETFs it runs. That follows recent moves at Fidelity, which started offering commission-free trades for 25 BlackRock iShares ETFs, and at Schwab, which removed trading fees on its line of ETFs in November.

Advantage: ETFs

Even before this development, there were plenty of signs that ETFs had been gaining ground. "With commissions going away, ETFs will gain market share over funds even more quickly," says Princeton economics professor Burton Malkiel, author of A Random Walk Down Wall Street (who also founded an ETF provider). That's because investors will start to wonder if they really even need to own traditional funds anymore.

Well, do you? Probably not -- at least if you plan to invest in broad-based ETFs. Those that track established benchmarks like the S&P 500 or the MSCI EAFE index of foreign stocks tend to be dirt cheap. For example, the average ETF that follows a U.S. broad market index charges just 0.36% in annual fees, vs. 0.66% for similar mutual funds.

Also, if you make frequent trades or if you rebalance a multifund portfolio often -- say, at least twice a year -- you don't need traditional funds anymore. And if you like to place bets on individual sectors, like technology or health care, commission-free ETFs would seem to make a lot of sense now. After all, you can invest in the Technology Select Sector SPDR ETF for 0.21% a year, while the typical tech-sector fund charges 1.6%.

The risk, of course, is that you can easily get carried away and narrow-cast your portfolio into oblivion. These days you can find ETFs that give you exposure to such fare as North American multimedia companies and Japanese small-cap dividend-paying stocks. Start to play too many hunches and you may be better off just going to the track.

What you need to know

Even if you don't have a gambling problem, there are certain things to keep in mind with ETFs.

For starters, while it may make sense to put new money to work in them, converting an existing portfolio of funds may not be cost-effective, since you'll take a tax hit on your gains. (There's an exception: If you're a Vanguard index fund investor, you can convert to the ETF class of the same portfolio, if there is one, without incurring taxes.)

Also, few 401(k) retirement plans currently offer ETFs as investment options. And while the overall number of ETFs is growing, if you're looking for one that invests in both stocks and bonds, or a portfolio managed by a stock picker, you'll probably find few choices that fit your goals.

Another thing to keep in mind: If you have a small account or rarely trade, you could incur other fees. At Vanguard, if your balances slip below $50,000, you'll be assessed a $7 to $25 fee per trade on non-Vanguard ETFs and stocks.

Finally, you have to understand how ETFs work. Like any other investment, they come with their own set of complications.

1. Don't go too exotic

Normally, there's a gap between the price buyers are willing to pay and what sellers will accept for ETF shares. Think of this as an additional expense you have to pay.

For ETFs that invest in widely traded investments, such as S&P 500 stocks, this so-called bid/ask spread may be only a few hundredths of a percentage point. But for less frequently traded assets, the spread can be two or three points or more. And that's on a regular day.

In the "flash crash" of May 6, when the Dow plunged nearly 1,000 points in just a few minutes before climbing back, the exchanges ended up canceling thousands of orders, two-thirds of them involving ETFs, where there was a 60% gap or more between trades.

Many involved specialized ETFs, such as those that invest in specific sectors or themes. To be fair, ETFs that track the broad market were also affected. Still, in general it's best to play it safe by sticking with broad-market ETFs where this spread is normally narrow.

2. Make sure your EFT is tracking its index

The point of an index fund is for it to perform almost exactly as the benchmark does, since that's what you're paying for. Yet iShares MSCI Emerging Markets ETF lagged its index by six percentage points in 2009.

This is what's known as tracking error. It occurs in all sorts of ETFs, but can be more pronounced in those that invest in less frequently traded securities, says investment adviser Rick Ferri, author of The ETF Book. If your ETF consistently misses its mark -- you can check by looking up its performance and that of its index on Morningstar.com -- consider switching to a different one or going with a traditional fund.

3. Be careful with commodities

While stock index ETFs are often tax-efficient, be aware that other types of ETFs, like those that invest in commodity futures, can generate sizable taxable gains. Also, ETFs that hold physical commodities, such as SPDR Gold Shares, are taxed as collectibles, so you'll pay a 28% rate on profits, not the 15% rate on long-term capital gains.

If you plan to invest in these types of ETFs, do it through an IRA. That way, you'll keep more of the returns you earn. With commissions going away, isn't that why you want an ETF in the first place?