History

• Though mutual funds date back to the 1820s, the American Stock Exchange (AMEX) launched the first ETF, representing Standard & Poor's 500 Index, relatively recently, in 1992. Because of their comparatively low management fees and ease of trading, ETFs have become a popular option for investors. According to ETFtrends.com, the total number of ETFs had grown to more than 800 by the end of 2009.
  
  

Features

• ETFs and investment diversificationEaster basket image by Crusted from Fotolia.com
  
  ETFs, like mutual funds, generally consist of a basket of different stocks which allow investors to own a proportional interest. Where mutual fund money managers control all of the action behind the scenes and issue proportional interests in their pool of stocks, buyers and sellers of ETFs control the action themselves, by trading shares via the major stock exchanges. Where money managers calculate the "net asset value (NAV)" of a mutual fund share only once per day, ETF share prices are updated throughout the day.
  
  

Structure

• The difference in structure allows you to make a dollar investment into a mutual fund, which can result in your receiving fractional shares. If you invest $4,000 into a mutual fund with an NAV of $15 per share, you will receive 266.67 shares. By contrast, if the ETF you want to purchase is selling at $15 per share, you must purchase either 266 or 267 shares; you can't buy a specific dollar amount.
  
  

Considerations

• Mutual funds allow for an investment strategy called "dollar cost averaging," or DCA. With this strategy, you spend a set amount of money at regular intervals to buy shares of a mutual fund. When prices are down, your dollar goes further, purchasing more shares. When prices are up, you purchase fewer shares. As a result, your average cost per share is lower than if you had purchased a set number of shares each month. Unfortunately, the ETF structure does not lend itself to a DCA strategy.
  
  

Warning

• Several brokerage firms have stepped up to address the DCA issue. When you have an account with a firm like this, you can specify how much money you wish to spend and on what stocks or ETFs. The firm will then purchase the stocks on your behalf, much like a wholesaler, and distribute the shares to its clients on a proportional basis. This allows you to pursue a DCA strategy where it is otherwise not possible. However, additional fees for this service may apply, so be sure to compare the cost of having a middleman with the cost of trading shares yourself through a traditional brokerage firm.