Last Updated Sep 28, 2009 9:03 AM EDT

Exchange-traded funds, or ETFs, are quite the rage among investors these days which is a great reason to think twice before letting any into your portfolio. You know the basics: They’re close cousins to index funds, holding baskets of stocks or bonds. You can buy ETFs replicating an investing universe as broad as the entire stock market or as narrow as shares of nanotechnology firms. Unlike index funds, however, ETFs trade on stock exchanges. And ETF assets have soared; they now exceed total assets of index funds.

ETFs do get a few checks in the win column: They are exceptionally tax efficient even more than index funds; they are cheap, and they offer a good way to get exposure to a sector that may be underrepresented in your portfolio. A lot of people who could be benefiting from ETFs arent using them, says Gary Gordon, president of advisory firm Pacific Park Financial in Aliso Viejo, Calif. and publisher of Web site ETFExpert.com.

That said, many ETFs probably dont belong in your portfolio particularly ones representing tiny slices of the market. The distinctive quality of ETFs that track minuscule market nooks is how easy they make it for you to shoot yourself in the foot. As MoneyWatch columnist Nathan Hale has pointed out, the average ETF returned -1.4 percent, annualized, for the five years through June but the average ETF investor lost 5.4 percent. The reason: Investors tried to time the market using ETFs and were predictably unsuccessful.

And dont even think about putting a dime in leveraged ETFs, which aim to provide double or triple an indexs daily return. Over the long term, as Hale has explained. their performance has nothing to do with the performance of the index they track.

ETFs Are Cheaper to Own

ETFs have two main advantages over index funds:

ETF expenses are often slightly lower. For example, the Vanguard Total Stock Market ETF levies an annual fee of 0.07 percent, compared with a 0.16 percent expense ratio for its sibling fund.

ETFs are often more tax efficient. Although both ETFs and index funds have to distribute any capital gains to shareholders annually, ETFs usually avoid realizing gains. Thats because an index fund might have to sell stocks to raise cash to meet shareholder redemptions, but redemptions are a nonissue for ETFs, which are traded between investors. So their investors rarely owe capital-gains taxes. The difference can be substantial. Morningstar examined capital-gains distributions by ETFs that track 27 indices and found that ETFs in 25 of the categories distributed no taxable gains during the previous five years; the other two types made tiny distributions. Next, the researchers averaged distributions from index funds tracking the same indices and discovered that 25 fund groups made capital gains distributions and eight distributed more than 4 percent of the funds net asset values.

But Index Funds Cost Less to Buy

ETFs dont stack up as well as index funds in at least three areas, however:

Commissions will reduce your returns. Whenever you buy or sell an ETF, youll pay a brokerage commission often $5 to $15, but a lot higher if you use a broker. The smaller your investment, the more a commission will eat into your returns.

Say you buy a single ETF share at $95 and pay a $10 commission. If your ETF gains 10 percent and you sell, paying another $10 commission, youre left with $83.50, a loss. The larger the amount you invest, the lower the impact of the commission: If you had started with $10,000, youd wind up with $10,979. But if you are investing small amounts on a regular basis dollar-cost averaging that commission is taking a little chunk out of every transaction.

ETFs may trade for less than theyre worth. Most of the 700 ETFs on the market rise and fall in value along with the index funds that track their benchmarks. But small and specialized ETFs sometimes trade at significant discounts or premiums to their underlying value. Thats because the price of these thinly traded ETFs often gets bid up or pushed down more than the securities within them. If you buy an ETF at a premium and later sell at a discount, your return might get nicked by a significant amount 5 percent or more is not unheard of.

Little ETFs may not last. ETF sponsors have started shuttering niche portfolios that failed to attract investors. Invesco PowerShares in May announced it would close 19 ETFs 15 percent of its offerings. The closing process tends to cause an ETF to trade at a discount, reducing returns for shareholders. (If you hold a niche ETF thats scheduled to close, you may want to wait for the liquidation. Then at least you wont owe a brokerage commission when you get your money back.)

Choose the Right Tool

ETFs make the most sense when you want to invest a large lump sum in a taxable brokerage account (ETFs tax advantages are irrelevant in a tax-sheltered account). ETF tax efficiencies can make a big difference over time, and the bigger the lump sum, the smaller the impact of commissions on your returns.

If you plan to put some cash in ETFs, stick to ones tracking major indices. They generally dont trade at big premiums or discounts and arent likely to get canned for lack of investor interest. You can research ETFs at Morningstar.com. Your brokerage firms site may also have useful ETF research capabilities. And, of course, the ETF sponsors have sites with details about their offerings.

Avoid ETFs, however, if you plan to make regular investments in them, especially small ones. Paying commissions each time will eat into your returns. ETFs dont make sense if you use a periodic investing plan such as dollar-cost averaging, says Scott Burns, director of ETF research for Morningstar.

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