Exchange-Traded vs. Index Funds

Exchange-traded funds and index funds aren't so different. They are both baskets of stocks that are meant to cover a broad sector or index and managed passively rather than actively. You're tracking the same well-known, 500-stock index whether you invest in the SPDR S&P 500 ETF or buy shares in the Fidelity Spartan 500 index fund.

The index fund business sure ain't chopped liver, but the ETF business has been booming of late. The number of ETFs on the market has skyrocketed this year more than ever, forcing me in recent months to look again at my long-held preference for cheap index funds. And look I did. The result: I don't think I will entirely change my spots, since I continue to believe that index funds are better much of the time. But I will grant that ETFs deserve consideration for certain investors in certain situations.

My biggest concern is that the action in ETFs is pushing toward narrower and more esoteric niches all the time. A preferred-stock ETF, anyone? How about global alternative energy? Or a pure play oil fund? Or a double-down leveraged fund, so when a stock index gains--or loses--10 percent, you gain--or lose--twice as much? None of these ETFs are bad. But these funds represent overspecialization of the kind that limits diversification and hurts most people most of the time. Also, keep in mind that the brokerage costs associated with trading ETFs might offset any tax or expense savings, especially if you trade frequently. That means you probably should not put small amounts of money into an ETF regularly since it will only rack up the brokerage bill.

Still, the increasingly diverse field of ETFs does provide some interesting new options, especially for entrepreneurs. Say your company is in the health-care industry and much of your net worth is tied up in it. From an investing perspective, the last thing you would want to do is invest more money in the sector. So you could use a handful of ETFs to construct a portfolio that mimics the S&P 500, say, but without any health care. In other words, invest a chunk in every other major sector in the index but medical. The variety of ETFs on the market today also gives you a chance to diversify beyond traditional stocks and bonds while sticking with a basket of holdings. The more ETFs that hit the market, the more options you will have.

Scott Bernard Nelson is a newspaper editor and freelance writer in Portland, Oregon.