What you need to know—and watch out for—when it comes to exchange-traded funds

Journal Report

ETFs are popular because they’re inexpensive to trade, tax-efficient and for the most part transparent. They appeal to long-term investors looking for simple low-cost portfolios and to active traders who want to buy and sell complicated financial products throughout the day.

But with more than a thousand funds to choose from, experts say investors need to pay close attention to what they’re buying. While ETFs can be an easy way to diversify a portfolio, some can be complicated and risky, too.

ETFs have 90% of the characteristics of standard mutual funds, says Paul Justice, Morningstar Inc. ‘s director of ETF research in North America. Both are bundles of stocks, bonds or other investments that can be bought and sold through a brokerage firm. But while transactions in mutual funds are processed only once a day, ETFs can be bought and sold on an exchange throughout the trading day, like individual stocks.

ENLARGE

Lloyd Miller

Most ETFs are index funds—compared with only about 5% of conventional stock and bond funds, according to Morningstar. Prices and yields of index funds are meant to move in tandem with the benchmarks they copy, like the Russell 2000, which measures small-cap U.S. equities, or the MSCI EAFE, which measures equities in developed countries outside North America. Just like an index mutual fund, index ETFs deliver broad exposure to a market or a sector without difficulties such as trying to buy lots of small overseas stocks directly.

Another big reason investors buy index ETFs: The funds have a lower average annual expense ratio than open-end index mutual funds: 0.56% of assets, compared with 0.98%, according to Morningstar.

WORD OF CAUTION: While five investment companies currently offer trading of some ETFs without commissions, brokerage firms generally charge fees to buy and sell ETFs. And for small investors, those commissions can add up.

A big difference between bid and asked prices for a fund’s shares also could cut into investor returns. Wide spreads are most likely with funds that trade infrequently or that invest in securities that trade infrequently.

Tax Efficiency

Both index ETFs and index mutual funds pay out very limited capital-gains distributions, since the components of most of their target benchmarks don’t change often. That means investors generally won’t owe capital-gains taxes until they sell their shares at a profit.

But an ETF’s unique technical structure makes it even less likely to pass along capital gains to investors. Although mutual-fund investors can see capital-gains distributions if the fund sells assets to pay investors leaving the fund, ordinary ETF investors won’t find themselves in this situation. That’s because when investors leave an ETF, they sell shares to another investor, so the fund doesn’t have to sell assets.

From my perspective, it is the most compelling reason to use ETFs, says Mark Armbruster, a Rochester, N.Y.-area investment adviser, who has been using ETFs for more than a decade, If they’re managed appropriately, there should never be capital-gains distributions.

WORD OF CAUTION: Investors should note that profits realized on some ETFs are taxed differently than profits on regular stock and bond funds and ETFs. For instance, gains on ETFs that hold physical precious metals—such as the No. 2 ETF by assets, SPDR Gold Trust —are subject to a 28% tax on collectibles and precious metals.

Shopping Around

ETFs give investors important information in a far more timely manner than mutual funds. ETFs typically disclose investing goals and update their underlying assets daily on the fund’s website. This information can also be found at Morningstar.com or IndexUniverse.com. Investors should look carefully at a fund’s underlying holdings to see the sectors that a fund is exposing them to, says Jim Ross, global head of SPDR ETFs at State Street Global Advisors, a unit of State Street Corp.

Historical returns and figures comparing a fund’s performance to its index should also be available on the sponsor’s website, along with information on fees and dividend payments.

WORD OF CAUTION: While investors can expect an index ETF to generally deliver the performance of its target benchmark minus the fund’s fees, ETFs don’t always deliver precisely. Some 68% of index ETFs either beat or fell short of their benchmark by more than their expenses in 2010, according to a study by Morgan Stanley Smith Barney. The funds missed only by small margins: Those tracking U.S. stock indexes deviated by an average of 0.57 percentage points, while funds tracking international indexes missed by 1.1 percentage points.

Both types of funds hewed more closely to benchmarks in 2010 than in 2009.

Making a Portfolio

A few ETFs can be combined to make a diversified, low-cost portfolio.

I use them as building blocks, says Russell Wild, an investment adviser in Allentown, Pa. Each building block includes a different asset class, says Mr. Wild, who adds that he usually builds a portfolio with a total expense ratio of 0.25% to 0.30% of assets annually.

Depending on a client’s needs, Mr. Wild likes to mix style funds like U.S. value and U.S. growth with international-market ETFs. Then he might throw in a fund that focuses on a sector of the U.S. stock market or an ETF of real-estate investment trusts. He will use a number of diverse bond ETFs.

But he often sticks with conventional mutual funds when investing in tax-free bonds because he likes the funds available and prefers not to worry about what can be wide bid-asked spreads in the muni-ETF universe.

WORD OF CAUTION: Since he’s usually aiming to give clients steady returns for years to come, Mr. Wild says he stays away from ETFs that follow niche markets. There’s too much volatility, he says.

Narrow Focus

As ETFs have proliferated, fund sponsors have introduced products that cover narrower and narrower market segments, which can be risky. For example, a fund focused on a small developing country could hold stocks whose fortunes are tied to one or two commodities.

Other niche funds are mostly useful for professional investors, who understand the risks involved with some of the strategies, including complex hedges and short sales, or selling borrowed shares in hopes that their value will fall making them cheaper to replace.

WORD OF CAUTION: A lot of bad ideas have come into the space, says Mr. Justice of Morningstar.

Before buying new funds based on a hot trend, Mr. Justice says, investors should examine them closely.

Mr. Ross says the large fluctuations common in narrowly focused ETFs, especially those that use complex strategies, are dangerous for the buy-and-hold investor looking for slow and steady portfolio growth.

Ms. Ensign is a staff reporter for The Wall Street Journal in New York. She can be reached at rachel.ensign@wsj.com .