ETFs: An Investor's Primer

An exchange traded fund or ETF is a fund that tracks an index, but can be traded like a stock. But plenty of mutual funds track indexes, directly or indirectly. So, what's the advantage of ETFs?

First, lower costs.  On average, ETFs are cheaper than competing mutual funds.

Second, ETFs are generally more transparent than mutual funds.  For example, many mutual funds experience style drift, where they drift away from their original objectives — that rarely happens with ETFs.

Also, ETFs disclose their holdings every day, in contrast to the quarterly disclosure from mutual funds. Continuous pricing throughout the day also gives ETFs an advantage over mutual funds, which are only priced at the market's close each day.

Third, ETFs are generally more tax efficient that mutual funds.  For example, capital gains distributions for mutual funds is sometimes significant, but usually zero for ETFs.

Finally, ETFs have been far more innovative in providing investors with access to new classes of investment. In the last year, for example, ETFs have allowed direct investment in commodities like gold, oil and natural gas, as well as real estate and timber. 

For stocks, the world is your oyster with ETFs: you can buy sectors like healthcare or energy.  You can also buy into country-specific funds like Taiwan, Singapore, or Brazil, or regional funds like Asia and Europe.

And the same goes for debt — you can buy U.S. debt or municipals or corporate debt, just like with a mutual fund, but you can also buy more exotic debt like emerging market debt.

Moreover, many funds allow you to leverage your investment: you can go 200 percent long the oil market, for example. Some funds are also designed to give you inverse exposure; that is, they allow you to short a market.

Bottom line: you can do everything a hedge fund does, and for relatively low costs.

© 2009 CNBC.com