One of the reasons (Exchange Traded Funds) ETFs have gained ground with investors is because of their low annual expenses. Also, investing in an index means that trades are generally made only when the index itself changes. As a result, the trading costs required by frequent buying and selling of securities in the fund are minimized. We discussed some general characteristics of ETFs in part one of our discussion earlier this week, so let's further examine the mysterious ETF.

What Makes an ETF So Special?
ETFs are another example of passive index investing, which means an ETF--much like an index mutual fund--doesn't require a portfolio manager or a research staff to select securities; this greatly reduces the fund's overhead expenses. On the other hand, you will pay a commission each time you buy or sell ETF shares (just like stocks). For you, this means that a lump-sum investment into an ETF will likely be more cost-effective than dollar-cost averaging, which involves frequent, regular investments over time.

ETFs and Taxes
ETFs can be relatively tax efficient. Because it trades so infrequently, an ETF typically distributes few capital gains during the year. In the past, there have been times when some investors found themselves paying taxes on capital gains generated by a mutual fund, even though the value of their fund may actually have dropped. Although it is possible for an ETF to have capital gains, ETFs generally can minimize the ongoing capital gains taxes you'll pay.

Other Reasons to Invest in ETFs

• Exposure to a particular industry or sector of the market
• Because the minimum investment in an ETF is the cost of a single share, ETFs can be a low-cost way to make a diversified investment in alternative investments, a particular investing style, or geographic region.
• Loss Limits
  
• The ability to set a stop-loss limit on your ETF shares can help manage potential losses. A stop-loss order instructs your broker to sell your position if the shares fall to a certain price.
  

How to Evaluate an ETF

1) Look at the index it tracks. Understand what the index consists of and what rules it follows in selecting and weighting the securities in it.

2) Examine how long the fund and/or its underlying index have been in existence, and if possible, how both have performed in good times and bad.

3) Research the fund's expense ratios. The more straightforward its investing strategy, the lower expenses are likely to be. An index using futures contracts is likely to have higher expenses than one that simply replicates the S&P 500.

A qualified financial professional can help you decide if (and how) ETFs might fit your long-term investing strategy.