What You Want to Invest In with Exchange-Traded Funds

Exchange-traded funds, like conventional mutual funds, hold a basket of securities (stocks or bonds). The primary difference is how the investor buys and sells his or her shares. Whereas investors in conventional mutual funds buy their shares from a fund company and sell them back to the fund shop when they want to redeem, investors buying or selling ETF shares must trade with other investors in the market, much as they would do if they want to buy or sell shares of an individual stock. For that reason, individual investors must use a broker when they want to buy and sell ETF shares.

How they trade

As the name suggests, exchange-traded funds are priced and traded on an exchange (AMEX, NYSE, or Nasdaq) throughout the day just like stocks. In contrast, traditional mutual funds' prices are set once a day (usually 4 p.m. Eastern) and investors must place their orders before that time in order to get that day's price. Also unlike mutual funds, you can do just about anything with ETF shares that you can with a stock, including setting market and limit orders, shorting, and buying on margin.

How they help you specialize

Providers of exchange-traded funds have increasingly aimed to provide funds for investors looking to invest in a narrow market segment. The ETF universe is flush with funds that focus on a single market sector, industry, or geographic region. Say you favor indexing and want to own a specific corner of the market such as biotech. There may not be many index mutual funds that track those sectors—but there are ETFs that do. Also, there are many more ETFs than funds that track single foreign countries. Exchange-traded funds offer investors a way to invest in a corner of the market without having to load up on just one or two individual stocks (plus, it's more cost-efficient in terms of brokerage commissions).

However, it's also worth noting that narrowly focused funds—whether ETFs or conventional offerings—can be too hot to handle for many investors. That's because investors are often inclined to buy and sell narrowly focused funds at inopportune times.