Exchange-traded funds sprung onto the investment scene nearly 15 years ago, but they’ve been stealing the spotlight from their more mature mutual fund cousins in recent years.

More commonly referred to as ETFs, they’re basically index funds (mutual funds that track various stock market indexes) but they trade like stocks. As such, they have all of the benefits of plain old index funds with some added punch. Their fees are often cheaper than index funds, though not always, and they may cost you even less in taxes.
So how exactly are they different? OK, here’s the technical gobbledy-gook:

An ETF’s underlying net asset value is calculated by taking the current value of the fund’s net assets (the value of all securities inside minus liabilities) divided by the total number of shares outstanding. The NAV is published every 15 seconds throughout the trading day. But the ETF’s NAV isn’t necessarily its market price. More on that in a bit.

When you purchase shares of a traditional mutual fund, the net asset value serves much like a stock price -- it’s the price at which shares are bought or sold from the fund company. At a traditional fund, the NAV is set at the end of each trading day.

ETFs, as noted, work a bit differently. Since ETFs trade like a stock, you buy and sell shares on an exchange at a price determined by supply and demand. That’s why an ETF’s market price can differ from its net asset value. The way ETF shares are structured helps keep the gap between those two figures pretty tight.

Many investors – including the pros – have taken notice of these funds. Money invested in ETFs has more than quintupled over the past five years. The number of ETFs has skyrocketed at the same pace – there are now hundreds to choose from. Sure, that’s not quite as many as the thousands of mutual funds that exist – but it is a lot of growth. And there are hundreds more on the way.

What’s all the fuss about? They’re likable for several reasons:

Costs: There are a lot of good ETFs that have very low fees compared with their traditional mutual fund cousins.

Taxes: ETFs are big winners in the tax department. As with any index fund, the manager of the ETF doesn’t need to constantly buy and sell stocks unless a component of the underlying index that the ETF is attempting to track has changed. (This can happen if companies have merged, gone out of business or if their stocks have moved dramatically). And given the special way ETFs are structured (trust us, you don’t want to know how this works), they’re often more tax-efficient than traditional index mutual funds.

Diversification: Like index funds, ETFs provide an easy way to invest in a specific part of the stock or bond market (say, small-cap stocks, energy or emerging markets), or the whole shebang (like the Standard & Poor’s 500).

Open Book: Again, since they track an index, you usually know exactly what’s inside an ETF. With traditional mutual funds, holdings are usually revealed with a long delay and only periodically throughout the year, with the exception of traditional mutual funds that track a specific index.

User-Friendly: ETFs can be bought or sold at anytime during the day, just like stocks. Mutual funds, on the other hand, are priced only once at the end of each trading day. If you’re investing for the long-term, this doesn’t really matter. It is nice to know, however, that you can usually exit an ETF at any time during the trading day.

There is a small catch. Since ETFs trade like stocks, buyers must pay a brokerage commission every time they buy or sell shares (online brokerage commissions range from a few dollars per trade to $20 per trade, depending on the broker LINK to Online Brokerage Guide. That can quickly add up, especially if you’re buying more shares each month. ETFs are great for lump-sum investors, but you should use a traditional index fund if you’re buying a little bit at a time.

Want to Know More?

• Who Should Buy an ETF?
• Getting a Great Deal on an ETF
• Grilling Guide: Questions to Ask When Shopping For an ETF