If you haven't heard of exchange-traded funds (ETFs), you're probably new to investing. They're a lot like traditional mutual funds, but they trade more like individual stocks. They also have some advantages over mutual funds -- such as the following:

  • ETFs can be bought with small sums of money. You can buy a single share, as long as the commission you pay your brokerage doesn't make that silly. For example, if you buy a share of SPDR (AMEX:SPY) for $125 and pay a $30 commission, you've just sent almost 25% of the value of your investment out the window from the outset. In general, you don't want to spend more than 2% of the value of an investment on commissions. Many mutual funds require minimum investments of several thousand dollars. (You can sometimes circumvent that, though, by buying into the fund via a retirement account.)
  • ETFs can be traded throughout the day, whereas with mutual funds, sales and purchases are generally transacted once a day. Funds are valued once a day, too, at the close of trading, whereas you can track the fluctuations in value of ETFs throughout the day. Of course, this is not a critical advantage for us Fools, as we prefer to buy for the long term and try not to focus too much on short-term volatility.
  • ETFs allow you to focus and invest in small niches, if you want. If you're very excited about the future of medical devices, for example, the iShares Dow Jones U.S. Medical Devices ETF instantly parks you in several dozen specialists in that arena, such as Thermo Fisher Scientific (NYSE:TMO), St. Jude Medical (NYSE:STJ), and Boston Scientific (NYSE:BSX). If, however, you'd rather focus on the broad market, SPDRs give you exposure to hundreds of companies, from business-machine specialist Xerox (NYSE:XRX) and organic-food maven Whole Foods Market (NASDAQ:WFMI) to luxury jeweler Tiffany (NYSE:TIF).
  • ETFs often charge lower fees than their mutual fund counterparts. The very inexpensive Vanguard S&P 500 Index Fund, for example, charges an expense ratio of just 0.15%, but the corresponding SPDR ETF charges even less -- 0.08%. Note, though, that some ETFs have relatively high fees, while many mutual funds sport relatively low ones.

ETFs growing in popularity
Investors have embraced exchange-traded funds. Check out these details:

  • As of July 2008, according to the Investment Company Institute, ETFs held $583 billion in assets, up 19% over their year-earlier level of $489 billion. Meanwhile, mutual funds saw their assets grow 3% over the same time period, to $11.6 trillion. Overall, mutual funds experienced a $92 billion net loss in assets between June and July, as investors pulled money out.
  • According to The Wall Street Journal, there are now more than 700 ETFs out there. That's up from 359 at the end of 2006. In the second quarter of 2008, some 60-plus ETFs were introduced. (Note, though, that many ETFs remain small, and that a few big ones, such as SPDRs, dominate the ETF universe.)

There is still much more money in mutual funds, but ETFs are growing with much more momentum. Some observers believe ETFs will eventually eclipse mutual funds.

Will ETFs win out?
But are ETFs going to put mutual funds out of business? I don't think so. In many ways, they're rather interchangeable. Investors will continue seeking out those investments that meet their needs and are convenient. If your 401(k) plan offers a range of mutual funds, you'll likely choose from among them. If you want to invest a small amount in a particular niche, an ETF might fit the bill best.

Besides, many fund companies, such as Vanguard (known for its low fees and investor-friendliness), now also offer ETFs. If one dies, the other will thrive, and the company will carry on, making its profits.

Learn more in The Motley Fool's ETF Center. And if you'd like some pointers to a bunch of outstanding mutual funds, give our Motley Fool Champion Funds newsletter a whirl. But in addition to such funds, remember that index funds offer compelling performance for minimal effort and cost.

Longtime Fool contributor Selena Maranjian owns shares of an S&P 500 index fund. Whole Foods Market is a Motley Fool Stock Advisor pick. The Fool owns shares of SPDRs. Try our investing newsletters free for 30 days. The Motley Fool is Fools writing for Fools.