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Why Exchange-Traded Funds Make Sense

Exchange-traded funds (ETFs) have long given traditional, actively managed mutual funds a run for their money.

Since the majority of mutual funds do not keep pace with the stock indexes, legions of investors are discovering that attaining average investment returns isn't so bad. While everyone has lost money on investments during the past year, some lost even more than they would have had they better diversified their money. While hindsight is always 20/20, investors would have fared better—and perhaps much better—with ETFs.

I think this is a particularly good time to invest in ETFs. More than ever, the direction of stock and bond prices is very uncertain. The stock market may recover soon, or it might take years. Interest rates may decline with deflation or rise with inflation. We are in an unprecedented economic crisis that makes the chore of separating investment winners and losers quite challenging, if not impossible. ETFs don't try to outguess the market, and that could be an advantage right now.

In case you're not familiar with ETFs, here's a primer:

The Basics of ETFs

ETFs are like mutual funds in that they hold a bunch of individual stocks and/or bonds. ETFs differ because they are bought and sold on the stock exchange, rather than by a mutual fund company. Most ETFs are passively managed, meaning that the funds simply hold a group of investments designed to replicate a stock or bond index. On the other hand, most mutual funds involve active management—buying and selling securities in hopes of providing better-than-average returns. ETFs, however, are designed to achieve the returns of a particular stock or bond index.

(By the way, an "index fund" is very similar to an ETF in operation. The primary difference is that you buy an index fund from a mutual fund company and an ETF on the stock exchange, just as you would a stock.)

To buy and hold an ETF, all you need is an account (brokerage, IRA, retirement), in which you can hold stocks.

Proponents of indexing argue that it is futile for mutual funds to try to beat the market. Studies show that over multi-year periods, few mutual fund managers consistently beat the market indexes. So, the argument goes, why pay a manager when simply buying a fund that equals the market average will work just as well, if not better? But there are some actively managed funds that pretty consistently outperform ETFs and invest in similar securities—although several previously outstanding mutual funds faltered badly during the recently turbulent stock market.

Advantages of ETFs

ETFs offer a number of advantages—in particular, low expenses. Because they are usually passively managed, there is no need to pay expensive analysts or managers for doing research. The computer buys and sells the fund holdings instead, and it does a pretty good job to boot. The annual expenses charged to investors in ETFs are usually, but not always, much lower than those of actively managed funds. If, as many expect, we are entering a period of low investment returns, the low expenses associated with ETFs can be particularly advantageous. Investors may also find the up-front cost of buying an ETF to be lower than buying a mutual fund with an "initial load" (commission).

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