(MONEY Magazine) – Not so long ago, you had two basic options if you wanted to play the stock market. You could write a check to a mutual fund and get instant diversification. Or you could take the time and trouble to build your own portfolio of individual stocks, which would let you trade to your heart's content and control your tax liability. You had a choice between simplicity and flexibility--you just couldn't get both. And then along came a Spider.

The Spiders, introduced in 1993 to track the S&P 500 index, heralded the arrival of a new type of investment vehicle called exchange-traded funds (or ETFs). They perform almost exactly like a traditional mutual fund, but they can be bought and sold instantly, just like a stock. With relatively little marketing behind them, Spiders and their ilk have already captured more than $20 billion in assets. And if you haven't considered buying one, you may soon: Barclays Global Investors--the second largest investment shop in the world, with almost $700 billion in assets--is launching a line of exchange-traded funds, dubbed iShares, that it hopes will be a major competitor to the traditional fund. The company plans to offer as many as 51 new index portfolios that will track almost every conceivable slice of the U.S. market. (Barclays Global Investors, which used to be the investment arm of Wells Fargo, essentially invented the index fund back in 1971.)

Could these new funds be the "killer app" that knocks mutual funds off their perch? Maybe. Can they make life easier for you? Definitely. Indeed, exchange-traded funds may be the best thing to happen to individual investors since Jack Bogle launched the Vanguard 500 Index fund in 1976. ETFs' most obvious selling point is that they let you trade in and out of the market or a particular sector as fast as you can point and click on your online brokerage account. (You can even short them or buy them on margin.) "If it's 10 a.m. and you want to buy or sell, you can find out the index price and get that price," says Lee Kranefuss, CEO of Barclays' individual investor group. "You don't have to wait for the market to close."

But if they work as advertised--and we'll explore that question in a moment--they should be a boon even for dedicated buy-and-hold fund investors. Since all of the products Barclays plans to launch later this year will be index-based, they will have extremely low management fees. They will also allow you to fine-tune your asset allocation: Many will track indexes that no mutual fund has followed before. Finally, their structure should make them extremely tax-efficient.

If these new-style funds catch on, even investors who stick to traditional funds could turn out winners. "The mutual fund industry is ripe for reinvention," notes Don Phillips, CEO of the fund-tracking firm Morningstar. "The cost of owning stocks has plummeted, but the cost of owning funds has remained stubbornly high." Some competition may finally change that equation.

SPIDERS, WEBS AND QUBES

Wait a minute: Aren't there already plenty of funds that trade on exchanges, namely closed-end funds? Yes, but ETFs differ from closed-ends in one crucial way. Closed-ends have a fixed number of shares; depending on investor demand, they can trade at a premium or a discount to the total value of the stocks in their portfolios, or net asset value (NAV). Mostly, they've traded at a discount, which is why closed-ends have been a bomb with ordinary investors.

The exchange-traded funds have gotten around that problem. Specialists at the American Stock Exchange, as well as large institutional investors known as arbitrageurs, issue shares when there are more buyers than sellers and redeem shares when there are more sellers than buyers. That should keep the price of the funds at or near their net asset value.

This system also gives the funds a tax advantage. ETF managers give the specialists stock, not cash, to meet redemptions. Thus the fund incurs no tax liability when shares are redeemed, and investors who don't sell aren't stuck paying tax bills generated by those who have flown the coop.

The original Spiders, or SPDRs (for Standard & Poor's Depositary Receipts), were the first products to adopt this innovative exchange-traded format. Since the 1993 launch of the Spiders (they are run by State Street Bank & Trust), 30 new ETFs have popped up on the Amex listings. Best known are the Internet-heavy Nasdaq 100 Trust shares (called Qubes because the ticker symbol is QQQ), and WEBS, managed by Barclays since 1996, which track individual foreign markets from Japan to Austria. Other exchange-traded products include Select Sector Spiders, which track various industry groups in the S&P 500, such as energy stocks or financial services; a Spider that tracks the S&P MidCap 400; and Diamonds, which mimic the Dow.

Thanks in part to the wild success of the Internet-heavy Qubes, assets in ETFs have more than doubled since the summer of 1998. That fact, plus Barclays' announcement of its iShares, has the fund industry buzzing. Bob Turner, chairman of the Turner funds, says this threatens "everybody who hasn't outperformed the market after taxes and after fees--and that's a pretty big group."

BUT WILL THEY WORK?

For these upstarts to take away a big chunk of the traditional fund business, the new products will have to prove that they can keep costs low and reliably trade at NAV. In theory, neither should be a problem. In practice, things might prove a little more complicated. Take costs. Spiders charge 0.18% a year, the same as the Vanguard 500 Index fund. (Barclays won't discuss the pricing of its new funds, but it has already launched a similar product in Canada that charges just 0.15%.) The only hitch is that you have to pay a brokerage commission every time you buy or sell shares of an ETF. Of course, that cost should be negligible for buy-and-hold investors.

What about NAV tracking? In all but some exceptional cases--notably Malaysia WEBS, after Malaysia imposed currency controls--the prices of ETFs have so far tracked closely to NAV. But Gus Sauter, manager of the Vanguard index funds (perhaps the ETFs' chief competitors), thinks that ETFs could break down during a panic. He points to what happened on 1987's Black Monday: "If you had sold S&P 500 futures during the '87 crash, they were at a 10% discount. I liken ETFs to futures because they rely upon the same arbitrage mechanism. If exchange-traded funds had been around in '87, they would have been at a 10% discount too." Barclays' Kranefuss counters that Sauter is "drawing a parallel between two things that use arbitrage, but in totally different markets." The fact is, though, that any investment may not perform as intended during market panics.

A SHARPER KNIFE

In the final analysis, there's a lot to like about the newcomers and not much to worry about. They stand to make fund investing more efficient than it's ever been. Of course, even efficiency has its downside. A good sharp knife is faster in the hands of a skilled cook but also makes it easier for a klutz to slice off a finger. Likewise, exchange-traded funds can make smart long-term investing easier and cheaper--but they will also let you do a lot of pretty dumb things, like day-trading funds until your brokerage costs and taxes eat away your gains. But Morningstar's Phillips, a well-known advocate of buy-and-hold fund investing, says that's not a fair criticism. "It's two different things, what you create and how people might use it," he says. "The same thing has been said about nearly every innovation in the fund industry, from 800 numbers to 24-hour fund in-formation." True enough. ETFs are not a substitute for smart strategy or sound investment principles. But they just may be a better way to invest.