Why invest in ETFs?

Exchange traded funds are being launched at an ever-increasing rate, both here and in the US. They have many advantages - but how well do they fit into your investment strategy?

In 2003, six new Exchange-Traded Fund investments (or ETFs) hit the U.S. stock exchanges. But in 2006, 132 Exchange Traded Fund investments were added to the market, bringing the total up to 333. Such extraordinary growth is big news - and shows no sign of slowing yet. In fact, one report says that there are almost 350 new ETFs that have filed to launch.

And just over the past week, we've seen the inception of new ETFs that provide leverage in areas such as basic materials, real estate and financials, as well as funds that allow investors to play the short side in those areas by buying an Exchange Traded Fund.

This growth is occurring for a reason. ETFs offer investors several advantages that give you more choice, more control, and more protection in your portfolio. But as with any investment vehicle, the key question is not how exciting or popular they are... but whether you should incorporate them into your individual investment strategy. And that depends on your goals and preferences.

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So let's delve into the topic, and see whether Exchange Traded Funds are right for you...

Investing in ETFs uncovered

The first major benefit of an Exchange Traded Fund is that it's a fund that tracks an index or sector, but trades like a stock on the major exchanges. So this immediately gives you the best of both the stock and mutual fund characteristics.

Here are some of the other key advantages that investing in ETFs provide:

Flexibility: Unlike traditional stocks, an ETF consists of a group of items, which is then offered as a security. You can group stocks together to mimic the performance of an index, a region, a country, or a sector. Exchange Traded Funds can also be used to shadow other instruments like bonds, or commodities such as gold and oil. So instead of having to become an expert in a particular field and scour the market for just one or two stocks, you can gain the benefit from an entire sector - and do so electronically, in any account, with any broker.

Low Cost: Compared to mutual funds (which have a similar but less extensive ability to group families of stocks together), ETFs have much lower costs. The average mutual fund fee is about 1.4%, while average Exchange Traded Fund fees are around 0.32%.

Transaction Ease: Mutual funds can only be bought or sold at the closing price every day. And most funds impose fees for anyone who holds them for less than six months. In contrast, ETFs trade like stocks on the major exchanges, predominantly the AMEX and NYSE, and you can trade them whenever you like, and as often as you wish.

Transparency: ETF owners know exactly what stocks or underlying assets they're holding, as opposed to mutual funds, which typically only disclose their top 10 holdings.

Investing in ETFs means you can buy actual commodities such as oil and gold without ever taking delivery of oil, or carrying an ounce of gold. Or you can buy foreign currencies without ever having to leave the U.S. So if the price of oil, gold, or the currency ETF you own goes up, so too will your ETF.

What's more... you can do this without having to pay huge commission fees. And you can also buy options on many Exchange Traded Funds.

Should you be investing in ETFs?

Because of their diversity, simplicity and low costs, ETFs are an increasingly popular way to invest for many types of investor. Let's see how they suit different investment styles:

If You're A Short-Term Trader Or Day Trader: Exchange Traded Funds have long been day trader favorites. Day traders have sustained massive liquidity in the top index ETFs, and drawn in new traders, too.

For example, the Nasdaq 100 Trust ETF (Nasdaq:QQQQ) is the most liquid stock in the world, trading over 112 million shares per day on average over the last month. Other day trader favorites include the Dow ETF - Dow Diamonds (AMEX:DIA)... the S&P 500 ETF - SPDRs (AMEX:SPY)... the Russell 2000 small-cap ETF - iShares Russell 2000 Index (AMEX:IWM)... and the oil ETF - United States Oil (AMEX:USO).

And if you want to sell any of these Exchange Traded Funds short, ETFs don't require a 'downtick' (a transaction that takes place at a lower price than the previous trade) to do so - a benefit greatly appreciated by day traders, and a big reason why these instruments lead the world in liquidity.

If You're An Intermediate-Term Trader Or Swing Trader: Swing traders also appreciate the liquidity and ease of short selling that Exchange Traded Funds provide. And the broad range of diversification available is a real boon to intermediate-term traders.

There are ETFs representing every geographic region and almost every sector imaginable. And using ETFs helps to spread your risk. You virtually eliminate the portfolio fallout from a single stock plunge, while also benefiting from the upside growth possibilities of many other stocks.

If You're A Longer-Term Investor Or Position Trader: Exchange Traded Funds are a very strong alternative to mutual funds for most long-term investors. With lower fees, tax advantages (little to no capital gains to pay) and no short-holding redemptions penalties, ETFs are increasingly prevalent in more long-term portfolios. Low ETF fees are also putting pressure on mutual fund fees - a situation that will eventually benefit fund investors, too.

Whatever your investment style, Exchange Traded Funds offer increased flexibility, diversity, and protection. And as the area looks set to continue its rapid growth in the coming months, we'll keep you posted on developments, and ways in which you can tap into these dynamic investment vehicles.

By D.R. Barton, Jr., Quantitative Analyst, Mt. Vernon Research for the Smart Profits Report

Update: for more information on investing in exchange traded funds, read: ETFs: profit from the City's best-kept secret