The debate about exchange traded funds versus mutual funds is an ongoing conversation that likely will never end. There are supporters and detractors in both camps, and as long as these products continue to exist, investors will pour trillions of dollars into both. Each has their advantages and disadvantages, but that's a discussion for another time. This article will explore some of the things that make ETFs unique, including how they are constructed, the different types of funds available and their historical performance.

ETF Construction
Exchange traded funds are bought and sold just like stocks. They're so easy to own, they have become a favorite of traders and in the process are making brokerage firms a great deal of money. Why buy a stock when you can trade an entire index or country? It's become very enticing to professionals and amateurs alike. Easy as it might be, it's important you know how they're constructed so you can understand the risks involved.

Briefly, shares of borrowed stocks are held in a trust to mimic a particular index. Creation units are then formed representing bundles of those borrowed shares and finally the trust issues ETF shares, which represent a small portion of the creation units. Those shares are sold to the public. The biggest risk with ETFs is liquidity. Because they can be sold short, if a panic ensued and a particular fund is shorted heavily, and at the same time it experiences severe sell orders, the fund might not have enough cash to satisfy those orders. It's a hypothetical problem, but one that is certainly possible.

Equity Funds
Most ETFs track market indexes. Some will mimic the index in its entirety and others use representative sampling, which deviates slightly by using futures, option and swap contracts, and the purchase of stocks sometimes not found in the index. If this sampling gets too aggressive, it can lead to tracking errors. Any ETF with a tracking error above 2% is considered actively managed. As ETFs become more specialized, they're something investors should continue to watch.

The proliferation of ETFs provides investors with an inexpensive way to achieve global diversification in their portfolios. Whether you want to capture a particular portion of the world's stocks or all of them, there's an ETF to make this possible; you can buy a country fund, which invests in the top equities of a particular country, or an emerging markets fund, which invests in a group of countries and the top companies in those markets. Not only are there funds available from a geographic perspective, there are those that use different styles such as value or growth investing. Further still, others invest in differently sized companies; whether you are after a small-, mid- or large-cap fund, there's something for everyone. However, it's important that you first determine your portfolio's equity allocation and then, based on those decisions, select actual ETFs to meet your investment goals.

Fixed-Income Funds
Most financial professionals recommend that you invest a portion of your portfolio in fixed-income securities such as bonds and bond ETFs. This is because bonds tend to reduce a portfolio's volatility, while also providing an additional stream of income. The age-old question becomes one of percentages. What amount should go to equities, fixed income and cash; this is commonly referred to as asset allocation. Bond ETFs are available in as many types as equity funds, probably more. Investors who are unsure of what type of bond fund to own should consider total bond-market ETFs, which invest in the entire U.S. bond market and provide a one-stop shop.

Commodity Funds
Before investing in commodity ETFs, it's important to understand why you are interested in commodities in the first place. Historically, commodities have had little price correlation with equities, providing investors with lower volatility. Experts suggest that strategic asset allocation accounts for 90% of a portfolio's return. However, it's not enough to have stocks, bonds, cash, commodities and real estate in your portfolio. You should also diversify within each of those asset classes. That's where ETFs come in. Investors can buy a commodity ETF that tracks the price changes of particular commodities like gold or silver or in a commodity stock ETF that invests in the common shares of commodity producers. The former has little correlation with stocks, while the latter, despite investing in commodities, is highly correlated. If your portfolio already contains equities, the straight commodity ETF makes more sense.

Currency Funds
As the world's currencies become more volatile and the U.S. dollar's role as a reserve currency slowly fades, investors wanting to protect the value of their U.S. denominated investments will seek options that provide a hedge against a depreciating dollar. One option is to invest in foreign stocks or foreign stock ETFs. However, this won't provide you with asset class diversification because foreign stocks are generally correlated with U.S. stocks. A better alternative is to invest in foreign currency ETFs. Whether it's a single currency or one with a broader focus, the intention here is to insulate your portfolio from a depreciating U.S. dollar. On the other hand, if the U.S. dollar is appreciating and you own foreign stocks, you can protect the value of those holdings by shorting the same currency ETF. It's important to remember that currency investing should represent a small portion of your investment strategy and is meant to soften the blow of currency volatility.

Real Estate Funds
Income investors wanting a little sizzle with their steak might consider real estate investment trust (REIT) ETFs. Whether you choose a fund that invests in a specific type of real estate or one that is broader in nature, the biggest attraction of these funds is the fact they must pay out 90% of their taxable income to shareholders. This makes them extremely attractive in terms of yield, despite the increased volatility compared to bonds; they are an excellent source of income, especially when short-term interest rates and inflation are near historic lows.

Specialty Funds
As ETFs have become more popular, a variety of funds have emerged to meet every conceivable investment strategy, much like what happened with mutual funds. Two of the more interesting are inverse funds, which profit when a particular index does poorly, and leveraged funds, which can double or triple the returns of a particular index by using leverage, as the name implies. You can even buy ETFs that do both. This is not recommended, though, because the returns compound daily, making them extremely volatile and unreliable as long-term investments.

Actively Managed
ETFs originally were developed to provide investors with a more tax efficient and liquid product than mutual funds. Passive by design, as they've become more widely accepted, investment managers have developed actively managed funds, albeit with higher management fees, which seek to outperform the indexes. When selecting any investment, whether it is a mutual fund or an ETF, a primary concern should be what you pay to own it. Considering most money managers underperform their benchmarks, it's recommended that you thoroughly consider the pros and cons of these funds before making an investment.

Historical Performance
Every ETF and mutual fund has tracking errors. The returns of the two products when tracking the same index are generally within a few basis points of each other. For most people, it comes down to what makes sense in your particular situation. If you are a do-it-yourself investor, ETFs probably make more sense. If you contribute monthly to an automatic investment plan, mutual funds likely will be your preference. Either way, it's important to understand what you're buying.

The Bottom Line
Since the introduction of the S&P 500 Depository Receipts in 1993, commonly referred to as spiders (SPDR), exchange traded funds have slowly made their way onto the investment landscape. Today, their mass appeal seems unstoppable. While they aren't for every investor, they certainly can play an important part in diversifying your portfolio, one ETF at a time.

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