How Investors Can Harness the Power of ETFs

Jan. 23, 2014 -- Investors who wisely seek to avoid active management — where investors or the managers of mutual funds they own choose stocks for portfolios — have long turned to index funds because they remove this discretion and the risk it brings. These funds track indexes, such as the S&P 500.

This form of investing is known as passive management, as opposed to the active management of picking stocks or hiring a fund manager to do so, as with mutual funds.

Over the past two decades, investors have flocked to index funds as a way to reduce investment costs (mutual fund managers must be paid) and capture the gains of the market instead of trying to beat it. After they were introduced in the 1970s, index funds at first slowly gained followers, but their popularity has grown significantly over the past 20 years.Yet, more recently, another form of passive management has been capturing investors' fancy: exchange-traded funds (ETFs). Like index funds, ETFs are funds whose performance is linked to certain segments or indexes of the overall market. These investments were first offered in the 1990s.

This relatively new investment vehicle is an excellent way to access the stock market without the risks of buying individual stocks. Women – or men -- seeking to become financially empowered should consider ETFs as a highly beneficial way to avoid the risks involved in active portfolio management.

ETFs have some key advantages over index funds. Compared with index funds, ETFs are:

• Less expensive. Initial fees are lower, and so are expense ratios (the perennial fees charged by investment companies). However investors should be aware that there is a wide range of expense ratios charged by ETF products, so be sure to compare these before buying.

• More tax-efficient, so you end up paying Uncle Sam less on capital gains.

• More liquid. With index funds, you must wait until the end of the trading day to sell shares. But because ETFs are traded on exchanges, as their name indicates, you can buy or sell at any time during the trading day.

• More targeted. Because a myriad of ETFs are available, when used correctly they can enable greater portfolio diversification, allowing you to spread your holdings over a broader array of companies of different sizes and industries to protect against risk.

• More flexible. Index funds tend to reinvest dividends automatically, but when you own ETFs, you get a check, so you can invest this money as you see fit. This way, it's easier to keep your portfolio in balance. For example, if you own an S&P 500 ETF, which consists of large companies, and this index has been doing quite well for a long period, you might buy ETFs composed of a different asset class, such as smaller companies, to keep your asset allocation from getting out of whack. Automatic reinvestment of dividends could grow your investment in large companies to the point where your total investment in them exceeds your original asset allocation, increasing your risk from a severe downturn in the performance of those companies.

You can buy ETFs wherever stocks are sold. As with stocks, you'll pay more for them through a traditional brokerage account and less through an online brokerage. Different providers market their ETF shares by different names. BlackRock calls them iShares; State Street Corp. calls theirs SPDRs (pronounced "spiders") and Vanguard Group, Vanguard ETFs.