by Archie M. Richards, Jr.
July 24, 2006

Exchange-traded funds (ETFs) are remarkable new investments that justify their increasing popularity.

ETFs are index mutual funds that can be traded like individual stocks. Let's say an ETF tracks an index of 1000 stocks. It actually buys those stocks in the proportions called for by the publisher of the index. But despite the fund having so many holdings, the ETF shares can be bought or sold with no hassle throughout the trading day.

Mutual funds have a significant problem that ETFs solve: The costs of buying or selling mutual fund shares are not paid by the people doing the trading. They're paid by the long-term shareholders. Here's why:

When an investor sells his shares of a mutual fund, the fund redeems them and pays the investor cash. The fund must either have the cash on hand, earning a pittance for the long-term holders, or it must sell stock, incurring transaction costs that also hurt the long-term holders.

On portfolio sales, furthermore, the fund sells its high-cost shares, leaving low-cost stock behind. Later, when the fund liquidates those shares, substantial capital gains are passed out to long-term holders.

Exchange-traded funds solve these problems. The costs of trading them are paid by the people doing the trading, not the long-term shareholders. Here's why:

Let's say you sell shares of Spiders, the exchange-traded fund that holds all 500 stocks included in the S&P 500 Index. You can't sell the shares to the fund. You sell them to another investor, most likely a Spider market maker.

When the market maker's inventory becomes too large, he sends some of his shares to the Spider fund to be redeemed. He can do so only in units of 50,000 Spider shares, with each unit currently worth about $6 million. In return, the fund passes out $6 million worth of S&P 500 index stocks (or multiples thereof) in the correct proportions, which the market maker then sells.

In other words, the fund receives Spider shares and transfers out stock in return. It's not a cash transaction; it's a tax-free exchange. The fund can therefore get rid of its low-cost stock, leaving high-cost stock behind. Later, when the fund must liquidate all shares of a particular stock, no capital gains are passed out to the long-term holders.

ETFs are a good deal for long-term shareholders. They also have other advantages that mutual funds, especially actively-managed mutual funds, don't have, as follows:

• The ETF shares can be traded any time during the trading day, using limit or stop orders. Mutual funds can be traded only at market after the close.

• Since the ETF is making exchanges with only a few people (those who can handle transactions with $6 million minimums), the ETF's operating costs are lower than those of index mutual funds and, not having to do stock research, much lower than those of actively-managed funds.

• ETF purchases and sales have no minimums. Many mutual funds insist on minimum initial investments of $2,000.

• ETFs can be held on margin or sold short. Holders of mutual fund shares can't do either one.

Now for the disadvantage of exchange-traded funds: Buyers and sellers must pay commissions. If the amount of money invested is $100, for example, and the commission is $50, you have a 50-percent loss right off.

I therefore recommend a brokerage firm called Foliofn (www.foliofn.com). For individual trades, the commissions are only $3.95. After you've accumulated $10,000 or more, paying $199 a year enables you to make up to 200 free trades a month - way more than you'll need.

With Foliofn, you don't have to submit purchases or sales in terms of the number of shares. Instead, you can specify the amount of money. Twice a day, all such orders are pooled and executed as a group. Foliofn allocates fractional shares, making the transactions come out to the penny.

Exchange-traded funds are terrific. For long-term investors, they're better than index mutual funds and way better than actively-managed mutual funds.