Dr. Scott Brown of Investment U says. “It seems we’ve been talking about bottoms and whether we reached it yet for quite some time.”

He goes on to say, “But this talk will shift soon to the ‘now what’ questions of what to buy when we do reach that magical point.” Here Scott discusses the Mutual Fund’s cousin, the ETF, and how to take advantage of investing in one.

Many will shun individual stocks for the safety of mutual funds. And with the explosion of index funds, we’ve never had a larger variety of options to help us diversify. These index funds are designed to yield a return equal to that of a particular index. They allow you to purchase a variety of assets as a low-cost, passive-investment strategy. And there are a number of indexes that specify sectors, stock indexes and international markets.

It’s a powerful strategy that allows you to slice and dice the global economy in a risk-managed approach. But we don’t like to stop simply at reducing risk and diversification.

There’s another cousin to the mutual fund and index fund families that many investors have heard of but haven’t taken advantage of. If you own mutual funds, indexed or otherwise, you need to know if using exchange-traded funds (ETFs) makes more sense for you. Here’s what you need to know about ETFs, the close relative to your mutual funds…

Exchange-Traded Funds – Index Mutual Funds on Steroids

Exchange-traded funds (ETFs) were first introduced in 1993, and are based on index mutual funds. They use similar principles, but have fewer management and transaction costs associated with them.

Unlike mutual funds, which can be bought or sold only at the end of the day when NAV is calculated, you can trade ETFs throughout the day, just like a share of stock.

• Exchange-Traded Funds are a portfolio of shares that can be bought of sold as a single unit.
• You own a proportionate amount of the shares held, with some ETFs even allowing transfers-in-kind.
• They can range from portfolios that track broad global market indexes all the way down to very narrow industry indexes.
• Exchange-Traded Funds are becoming a preferred way for investors to get all of a mutual fund’s benefits, with none of the downsides.

Think of ETFs as mutual funds on steroids.

Exchange-Traded Funds Becoming More Popular

While exchange-traded funds are becoming more popular by the day, they weren’t always so highly regarded. In fact, the creator of The Vanguard 500 Index Fund was against them and vigorously attacked the possibility of their success. In the end, John Bogle ended up adding a whole series of ETFs to the Vanguard family.

ETF investments quickly competed against indexed mutual funds. By early 2007, over $400 billion was invested in over 300 ETFs in three general classes:

• Broad U.S. market indexes,
• Narrow industry or “sector” portfolios,
• And international indexes.

The first ETF, like the first indexed mutual fund, matched the S&P 500 index and was given the symbol SPDR for Standard and Poor’s Depository Receipt. Many know it by its nickname, the “spider.”

Spiders spawned many new exchange-traded fund products like “Diamonds” that are based on the Dow Jones Industrial Index DJIA, Qubes based on the Nasdaq 100 index, and WEBS based on the World Equity Benchmark Shares of a portfolio of foreign stock market indexes.

The Advantages of Exchange-Traded Funds Over Indexed Funds

A big advantage of an exchange-traded funds over a conventional index fund is that they trade continuously throughout the day. You can buy and sell ETF shares just like a share of stock, while with an indexed mutual fund – where the net asset value is quoted – you have to place an order to buy or sell but that doesn’t transact until after the market.

This can be frustrating if your technical analysis indicates a buy or sell trigger at some point during a trading session but the market moves too far for you to take advantage of it by the end of the trading day.

And unlike mutual funds, exchange traded funds can be sold short of purchased on margin like a share of stock.

When you analyze these factors in light of the fact that options also trade on exchange-traded funds you can place positions in the general market, global market, or industry sectors, where you can:

• Employ protective hedges with puts or calls on your long or short ETF portfolio.
• Use combined buy-write options strategies where you collect premium from the short sell of an option to compensate for the cost the long options – bull and bear spreads, calendar spreads, diagonal spreads, butterflies, iron condors and so on, are all available to you trading ETFs but NOT with indexed mutual funds.

Exchange-traded funds also have tax advantages over mutual funds:

• When large numbers of mutual fund investors redeeming their shares – but you don’t – the fund has to sell securities to meet the redemptions. This creates a capital gains tax that is passed on to the remaining shareholders.
• Which means you end up paying the other guy’s tax obligation!
• In an exchange-traded fund, when somebody else sells, they have to pay the tax, not you.
• And when very large trades redeem their positions in the ETF, the transactions is settled with shares of stock in the underlying portfolio – not triggering a stock sale by the fund sponsor and no bogus tax bill to you.

Using Exchange-Traded Funds: How to Put Your Index Mutual Fund on Steroids