From Spiders to PBJ (the ticker, not the sandwich), the world of exchange-traded funds keeps expanding. If you want the diversification of a mutual fund and the convenience of being able to buy or sell whenever the market is open, you might want to take a look at ETFs.

How they work
ETFs are similar to index mutual funds in that they track various indexes that can cover a broad market, a particular sector, or an international benchmark. That means you can pick and choose the extent of diversification you want, and in the investment world, diversification is a good thing to have in your portfolio, since it reduces risk. The other neat thing about ETFs is that you can determine the date of a capital gain or loss, a good thing for tax planning.

One popular fund, the Spiders (AMEX:SPY) ETF, tracks the S&P 500 and gives you exposure to the returns of large-cap U.S. securities. Others let you invest in entire countries, such as the iShares MSCI-Australia (AMEX:EWA) fund, which provides exposure to the returns of companies Down Under. Not only is Australia far, far away, but it also depends heavily on extractive industries such as mining, so its economy is less diversified. That's one of the things to watch out for when considering certain focused ETFs.

An example of an even more focused ETF is the PowerShares Water Resources Portfolio (PHO). This fund, based on the Palisades Water Index, gives you exposure to companies that are in some way involved, not surprisingly, in water. With water being so essential, this may be a good sector to focus on in the long run. As of Oct. 31, Watts Water Technologies (NYSE:WTS), Franklin Electric(Nasdaq: FELE), and Layne Christensen (NASDAQ:LAYN) each accounted for just a little more than 3.4% of the fund.

The upsides
Unlike traditional index mutual funds, which usually can be purchased or redeemed only at an end-of-day closing price, ETFs trade on stock exchanges all day long. The pricing of ETFs is continuous during normal trading hours, so just as with a stock, you can get a price at which to buy or sell your fund when the market is open. Price information is available from your broker or any of the various stock-quotation systems. Or, if you have more patience than most of the MTV generation, you can obtain the closing prices when they're published in major newspapers the following day.

As index trackers, ETFs generally have low stock turnover -- i.e., the purchases and sales of securities within a fund's portfolio. This in itself is tax-efficient because the fund doesn't realize capital gains. In addition, individual capital gains on your fund holdings aren't realized until you sell your shares. This means that you can determine when capital gains and losses will occur, which is great for tax planning and reduction.

If you want to make like a lemming and follow other investors into hot sectors such as gold and energy, you have several ETFs available. The streetTRACKS Gold Shares ETF (GLD) fund is linked to the price of the precious metal. The Vanguard Energy ETF (VDE) is an option for those who see energy as an attractive bet, since the fund tracks an index of U.S. companies in the energy sector. As of June 30, ExxonMobil (NYSE:XOM), Chevron (NYSE:CVX), and ConocoPhillips made up 19.5%, 10.7%, and 8.2% of the fund, respectively. Beware, though, that there is a downside to that relatively large exposure to ExxonMobil. Guess what that large exposure reduces? Diversification. If you buy this fund, pray that nothing bad happens to ExxonMobil.

If you think it's time to put some tasty treats in your portfolio, the PowerShares Dynamic Food & Beverage Portfolio (PBJ) invests in common stocks of -- you guessed it -- food and beverage companies.

If you're a little, well, shy about committing your money to a particular sector, the iShares Lehman 1-3Yr Treasury Bond Fund (SHY) is a relatively low-risk fund that seeks to achieve the price and yield performance of the short-term sector of the U.S. Treasury market.

If you have only a few thousand dollars to invest, you can add a lot of variety to your portfolio with a stock, bond, international, real estate, or even specialty commodity ETF. Essentially, ETFs are only a broker call or an email away. That's good, but it also means you'll pay brokerage commissions for purchases and sales, so you get hit going in and out of these funds. But with Internet trades costing less than $10, and with your ability to purchase as little as one share of most ETFs, you can build a broadly diversified portfolio relatively cheaply.

Potential pitfalls
Keep in mind, though, that even though discount trades can make trading these funds easy, it's extremely difficult to make a profit timing the market, and the ease of trading could entice you to buy and sell more frequently than you should.

Other than having to pay a commission to trade an ETF, another thing to keep in mind is liquidity. ETFs are subject to wide spreads in bid/offer prices. We're not talking about the old waistline here, but rather the price you pay or will be paid. The more buyers and sellers a fund has, the better the liquidity.

Some ETF critics claim that one of their drawbacks is that they offer only index-based investment strategies. That's true, and you won't get better than market returns from an ETF, but the upside is that ETFs also charge very low fees. With many actively managed funds charging high fees and failing to achieve even market performance, it's hard to see the problem with market returns at low fees.

The bottom line
ETFs can be a useful addition to your portfolio, and as you can see from the funds we've mentioned here, you have many choices available. For most tastes and risk tolerances, there's an ETF suitable for you. If none of the current fund offerings fit your needs, just wait -- a new ETF may soon be created that is just right for you.

To learn more on ETFs, visit our ETF Center.

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This article was originally published in August 2006 by Zoe Van Schyndel. It has been updated by Fool sector head Joey Khattab, who owns Spiders. The Motley Fool has a disclosure policy.