By now even most uninitiated investors have heard of index funds. As far as investment options go, they are, well, hot.
It's a wonder that it took 20 years for someone to tweak the trend and come up with another way for investors to buy into indexes. Exchange-traded funds (ETFs) entered the scene in the early 1990s, attracting billions of investors' dollars -- $121.6 billion as of June 2003, to be exact, according to the Investment Company Institute.
Both ETFs and index mutual funds track the performance of an index. An index fund, though, is operated like a mutual fund. An exchange-traded fund is a bite-size version that gives you all the benefits of index investing, with the handiness -- and costs -- associated with owning an individual stock.
Chomping at the bit, yet? Before jumping in, we have 600 choice words for you:
Step 1: Decide if an ETF is right for you: If you plan to dollar-cost average (adding small, systematic amounts to build a portfolio), ETFs are not ideal. They don't offer direct investment programs, so dollar-cost averaging would rack up trading costs that far outweigh any cost benefit over a traditional index fund. For you, a more efficient route would be a no-load, low-expense index fund.
If, however, you'd like to add an indexing element to your portfolio and are prepared to invest a lump sum, ETFs can provide a lot of flexibility. They can be bought or sold anytime the market is open. They can also be optioned, shorted, and margined (tread with caution here, though). Traditional index funds, on the other hand, can only be redeemed at the closing price of each day.
Step 2: Consider taxes. ETFs are very tax efficient. By construction, investors don't pay any capital gains from internal turnover. Of course, when you sell your ETF shares, should you be fortunate enough to do so at a profit, you'll be on the hook for capital gains taxes. In the eyes of our friendly Internal Revenue Service, it would be just like selling any other stock for a profit.
Step 3: Get the wheels in motion. Got a brokerage account? Then you're set to start investing in ETFs. ETFs trade on the American Stock Exchange (Amex) and have snappy nicknames like Cubes, Spiders, and Diamonds. They also have tickers, just like any other publicly traded company. Spiders, for instance, track the S&P 500 and trade under the ticker symbol SPY.
Step 4. Pick an ETF. There's an ETF to represent virtually any segment of the market -- everything from the S&P 500 to the Wilshire 5000. Want to track the Nasdaq 100 with an ETF? No problem -- try QQQ. Looking to follow the MSCI Index for Hong Kong? You can do that, too with EWH. Or if you want to invest in the more pedestrian but Fool favorite S&P 500, that's easily within reach by buying SPY.
Step 5: Keep fees in check. Don't get carried away with ETF fever. Remember, it's important to keep your costs under control. Much like most of their index fund brothers, ETFs have a very cost-efficient structure. Annual expenses range between 0.1% and 0.65% and are deducted from dividends. Shoot for one with a ratio below 0.4%. The only other fees you'll encounter with ETFs will be your broker's trading commissions, which leads us to...
Step 6: Don't go crazy. Think of ETFs like you would any other equity investment -- as a long-term investment tool. The moral: Don't rack up trading commissions or capital gains taxes by actively trading.
