by Kent Moore

Created on: June 22, 2009

Investing in exchange - traded funds (ETFs)

Investing in ETFs, depending on an investor's unique situation and long-term goals, may be a suitable approach to building a well diversified portfolio.

Two of the most suitable ETFs are broad market stock ETFs and broad mark bond ETFs. Broad stock market ETFs are designed to match the performance of indexes such as the S&P 500. However, you must be careful because some ETFs that are referred to as "broad market" may not be that well diversified. Some indexes, such as the S&P TSX Composite, are heavily weighted in only two or three sectors. This means that an investor must understand how an ETF is constructed and weighted before investing.

While broad market ETFs can be suitable for an investor, there has recently been a wave of sector specific, niche and leveraged ETFs released. These funds are unnecessary, riskier and investors may be tempted to trade these specialty ETFs more frequently.

What is an exchange-traded fund (ETF)?

An ETF is a basket of securities that trades throughout the day on an exchange. In general, ETFs are passively managed portfolios that are designed to track the return of a particular index. Since ETFs trade on an exchange in the same way as a stock, they are priced continuously and the price fluctuates throughout the day. ETFs may pay a dividend if the dividends of the stocks in the portfolio exceed the ETFs expense ratio (which is the amount shareholders pay annually in expenses and fees).

Five characteristics of an ETF

1. Passive management | The goal of most ETFs is to mirror the return of their benchmark indexes. This is one way in which ETFs differ from actively managed mutual funds - mutual funds try to beat the return of their benchmark indexes.

2. Tax efficiency | ETF investors can incur passive capital gains while holding shares if gains are produced by the trading that is conducted within the portfolio. This can cause tax consequences for investors who own the shares. Since ETFs hold the same securities as their indexes, stocks are usually only added to or removed from the portfolio when there is a change in their underlying index, which happens less frequently for broad stock market indexes. This limited turnover reduces the potential for capital gains to be generated and passed on to ETF shareholders.

3. Relatively low expenses | ETFs have an annual expenses ratio for management and other expenses of the fund. However, since most ETFs are

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