A spider isn’t just a subject for science classes anymore. It’s also a type of exchange-traded fund (ETF),  an investment that combines the diversification and cost-effectiveness of index funds with the trading flexibility of stocks. ETFs fall into several different styles and types to fit diverse investment strategies and asset allocations. As with any investment vehicle, they have both advantages and disadvantages that should be considered before adding ETFs to your overall investment strategy.

ETFs are “baskets” of equities, shares of which are traded on an exchange. Like stocks, they can be traded throughout the day at real-time prices. Like index funds, ETFs usually have low expense ratios and portfolio turnover because they aren’t “actively” managed. The managers simply choose the underlying stocks so the “basket” matches the makeup of the appropriate index.

ETFs might be designed to track a broad market or a sector.  Standard & Poor’s Depositary Receipts, or Spiders (SPDRs), is the brand name provider that spawned the ETF industry with the SPDR S & P 500 ETF in 1993.  SPDR ETFs now cover numerous sectors of the S&P 500 (not just the largest U.S. companies, as the original product does), as well as other defined-market capitalization groupings. Other brands of ETFs include Qubes, which mirror the largest 100 firms of the technology-driven Nasdaq Composite Index, and Diamonds, which move in step with the 30 large-cap companies that make up the Dow Jones Industrial Average. The increasing popularity of ETFs has resulted in increasing numbers and types being rolled out.

One significant drawback is that their ease of trading may encourage more frequent trading, so ETFs may not be the best fit for investors with a long-term strategy and goals.  Because ETFs trade like stocks, commissions and fees apply to each trade. Depending on how often the ETF is traded, those fees can add up quickly and reduce your investment’s performance.

One advantage of ETFs is their potential tax-efficiency. Unlike with mutual funds, ETFs need not be sold to satisfy investor redemptions, a move that can create taxable capital gains for mutual fund shareholders. However, certain ETFs do distribute capital gains to shareholders. Investors will generally want to re-invest those capital gains distributions to defer taxes, and this results in additional fees if re-vested to buy more ETF shares.

By drawing on benefits of both index funds and stocks, an ETF can potentially help reduce portfolio risk and increase returns. To learn more about ETFs or for help sorting out whether they may be a good fit your portfolio, contact your financial advisor.

Portions of this article was provided by the Financial Planners Association and Perspective Financial Services, a local FPA  member. © 2013 S&P Capital IQ Financial Communications. All rights reserved.