Indexing has become an increasingly popular investment strategy in recent years. If you invest in an index fund you’ll get exposure to the broad market with low management costs.
A new type of index fund is gaining favor: exchange-traded funds (ETFs), which are considered to be more tax-efficient. There are 30 ETFs on the American Stock Exchange, tracking various indexes, and more are about to be introduced.
Popular ETFs include Diamonds (DIA), which track the Dow Jones Industrials; and Cubes (QQQ), which track the high-flying Nasdaq 100. There also are “sector Spiders,” which follow industries such as technology, and 17 WEBS, each of which tracks one foreign country. All ETFs trade like stocks so they can be bought and sold through brokers.
ETFs don’t make capital gain distributions so they don’t pose tax headaches for buy-and-hold investors. With mutual funds, on the other hand, taxation can be a problem. In addition, some investors prefer ETFs to index mutual funds because the former can be bought on margin, sold short, and traded subject to limit orders. ETF trades are done instantly; with a mutual fund, transactions are not priced until the end of the day. Some observers express concern that a market break could lead to a surge of redemptions in index funds, in which case the ability to immediately trade out of an ETF could be a plus.
