60 Seconds to an ETF

Want to own an index fund without owning an index fund? Say what? Give us 60 seconds and we'll give you the low-down on exchange-traded funds -- the index funds that trade like stocks.

0:60 Learn the differences between index mutual funds and exchange-traded funds (ETFs).Both investment vehicles track the performance of an index. An index fund, though, is operated like a mutual fund. (Not particularly shocking, we know, given that the word "fund" is there.) 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.

0:54 Decide if an ETF is right for you: What kind of investor are you? Handsome, we know. But let's look a little deeper. If you plan to dollar-cost average (adding small, systematic amounts to build a portfolio), ETFs are not ideal for you. 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 (not that we necessarily support doing any of those things with ETFs). Traditional index funds, on the other hand, can only be redeemed at the closing price of each day.

0:47 Consider taxes: The tax consequences of owning an ETF should also be weighed before you buy. The good news is that there really aren't any! 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.

0:43 Get the wheels in motion: Got a brokerage account? Then you're set to start investing in ETFs. (If not, visit our Broker Center. Finding a broker isn't brain surgery, we promise.) 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.

0:33 Pick an index: Now the fun begins. There are lots of different ETFs, tracking everything from the S&P 500 to the Wilshire 5000. You can find an ETF to represent virtually any segment of the market you'd like to track. 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.

0:19 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...

0:07 Don't kill your returns: We don't like the idea of investors trading in and out of ETFs repeatedly, or going on margin to the hilt to buy them, anymore than we do any other stocks. We support their use as a long-term investment tool just as we do traditional index funds. The moral: Don't rack up trading commissions or capital gains taxes buy actively trading. Let your ETFs work for you.

Got another minute?

• Interested in buying some ETFs, but don't have a brokerage account? Check out our 60-Second Guide to Choosing a Broker.
• Learn about indexes that track small-cap stocks, foreign stocks, and others, in our Index Center.
• Learn more about mutual funds in our Mutual Fund area.