If you’ve been living under a rock and haven’t heard of exchange traded funds (ETFs), today’s lesson is for you (though I still can’t figure out how you managed to get a wi-fi signal under there). An exchange traded fund is:

– often referred to as a “basket” of investments. This means a single ETF includes a collection of investments, so to some degree, you’re already diversified.

– investments that share a similar quality, such as all large companies, all oil companies, or all value-oriented firms. Sometimes they’re really quirky: all water companies, for example.

– usually aligned with an index, which is an unmanaged benchmark set of investments that people use to gauge the economy or success of their own investments. Some popular indexes are the Dow Jones Industrial Average, the S&P 500 and the NASDAQ 100. Some unpopular indexes are the Joe’s Favorite Boardgame Index and Best Doughnuts Ever Index, though I tried diligently to gain support for both products.

– unmanaged OR managed on “autopilot” based on predetermined criteria, not based on the whims of a manager.

According to Clark Howard, exchange traded funds are the fastest growing investment type, and with good reason. Although they compare favorably with mutual funds, they’re more attractive in many portfolios for a few reasons:

– Lower fees. Some investors believe that lower fees equal better results. I’m not that guy. But I do think that if I’m going to get middling results, why not pay less money for it? The average mutual fund fee is around 1.4 percent, while the average ETF fee is only 0.32. That’s a HUGE difference in fees. Think it isn’t a big deal? Check out this:

Story Problem!

Sally just sold her illegal street-rod and wants to invest the $10,000 profit. Over one year, an exchange traded fund will add an additional $108 more to her account than that average mutual fund her friend Jimmy uses. That $108 cost savings, invested for 30 years at 7 percent nets Sally an extra $11,738.01 for free, which she plans to invest in new headers and purple undercarriage lighting when she’s 65 years old. ….stuff Jimmy won’t be able to afford. HAHAHAHA

– Many investment options. A few years ago there were limited choices. Now if you can dream it, someone has probably created an ETF to emulate that investment idea.

– Downside protection. As a side benefit, exchange traded funds trade like a stock, meaning that you can use protection measures such as stop losses on an ETF. Stop losses can’t be used with mutual funds, because they only trade once daily.

Exchange traded funds aren’t the end-all, be-all. There are downsides:

– You’ll pay trading costs when you buy and sell exchange traded funds. This will take some of the $822 back out of your pocket.

– You won’t beat the index you’re competing against. Because your investment is tied to the performance of the applicable index, your returns will most often be slightly lower than that index (because of fees).

– In fact, your results will be pretty ordinary. The only way to beat the index is to invest in the hottest investments only. By capturing the returns of the entire index, you’re getting the best and worst picks of the crowd.

There are other downsides, but they’re more technical (such as dividends and volatility due to stop-losses). For the beginner, this is what you should know.

When is an exchange traded fund in order?

Just like you don’t bring your own hot dogs to a wedding reception (lesson learned), there is a time and place for exchange traded funds. Here’s where they really shine:

– ETFs are a great “hull” of a portfolio. Think of a ship’s hull. It holds the rest of the ship above water and cuts a straight path. Any position that you need in the portfolio to mimic market conditions AND you aren’t going to trade often is perfect for an ETF for two reasons: 1) trading fees won’t kick your butt (you don’t trade in and out of the “hull” of your ship) and 2) you’ll get the same diversification as a mutual fund at a lower cost.

– You want market-like results but fear volatility. I love psychology. Everyone wants two things from their portfolio (what’s with the two things today?): 1) Big returns and 2) no risk. Am I right? Of course I am. The market doesn’t give you Burger King (have it your way), but you can limit volatility. As I explained earlier, exchange traded funds trade all day long, while mutual funds only trade once per day. Why’s this a big deal? Mutual fund investors can’t limit volatility during a trading session. ETF investors can use instruments like stop losses to curb losses. Sure, you’ll pay trading fees, but if the market tanks, your nest egg will only have dropped to your stop loss point.

– You want to take a risk, but don’t want to bet on a single company. Because some ETFs emulate sectors of the market, you can gain exposure to precious metals, commodities and other risky asset classes without betting the farm on a single stock, bond or commodity. Sure, you can do this with mutual funds also, but with the ability to buy and sell all day long (as described above), ETF investors enjoy a greater degree of flexibility.

– Wrap and low cost trading accounts. If you have an account where you don’t pay for individual trades or pay a minimal amount, trading fees on ETFs are no longer a bridle on your results.

So, minions, that’s our Exchange Traded Fund lesson for the day.  Here’s my question to you: If you use exchange traded funds in your portfolio, how do you deploy them? Why do you like them? If you don’t use ETFs, it may be a marvelous idea to read the comments and see if some of our brilliant readers have additional ideas. Enjoy!