I often see personal finance articles mention exchange-traded funds, or ETFs, as if every reader knows exactly what that means. I think I know something about investing, and I'm a little cloudy on what ETFs are, so I'm guessing others are, too. Therefore, I investigated further, and here's my understanding of ETFs, in layman's terms that are hopefully clear (and maybe even accurate).

Exchange-traded funds trade like single stocks, but they're actually made up of many stocks all mushed together, sort of like neapolitan ice cream. Or, perhaps more appropriately, like mutual funds, which also allow you to buy small slices of multiple stocks within a single share. ETFs include things like SPDRs (pronounced "spiders"), which track the S&P 500, or the Nasdaq 100 tracker QQQ. They can also be industry-specific, like energy ETFs, or country-specific ETFs, or other variations.

Still sounds like mutual funds, right? So, if ETFs are just like mutual funds, what's the hubbub?

Well, ETFs are different than mutual funds in a number of ways, which may make them more or less attractive depending on your investing preferences.

Trading Flexibility

As I mentioned, ETFs are bought and sold the same way stocks are sold, via a broker. On the upside, you get the flexibility to buy or sell an ETF any time you want throughout the trading day, unlike mutual funds, which only are bought or sold at the day's closing price. So, if you're an active trader, you could potentially buy an ETF in the morning of a day that you're expecting a big pop in the S&P, or in gold, or whatever, and sell it again at a nice profit when you think it's at its zenith. You can't do that with a mutual fund.

Trading Inefficiencies
Again, ETFs are bought and sold like a stock. Therefore, even though they are based on the value of an underlying bucket of stocks such as those of an index like the S&P 500, the actual price you buy and sell them for can still be higher or lower than the underlying value. Just like Home Depot may be selling for less than what you think it's worth because no one wants to buy it today, an ETF can sell for less than it's worth.

(This isn't a perfect example, as ETFs don't usually vary widely from the values of the stocks that make them up, but you should understand that ETFs are subject to supply and demand like any other stock.)

Another important point: you'll usually buy ETFs at the Ask and sell at the Bid, just like other stocks. If you buy individual stocks, you know about the spread--the stock price is $10 but you have to pay $10.03 to actually purchase it, meaning you're a little behind from the moment you purchase a stock. Same is true of ETFs--this is not true of mutual funds.

Fees

But what about the costs? Again, because the ETF is bought and sold as a stock, you'll pay a commission on every purchase and sale of an ETF. Contrast that with a mutual fund, which you can buy directly for no fee in most cases. In that case, an ETF can be more expensive, especially if you trade it often.

An ETF will also be much more expensive if you like to contribute on a regular basis versus just putting one lump sum out there and letting it ride. If you regularly add $500 or $1000 to your mutual fund, it doesn't cost you anything. If you regularly put that same $500 or $1000 into an ETF, you'd pay a broker commission each time. Yes, you can get online trades for 7 or 8 bucks these days, but they'll still add up if you make regular, systematic purchases.

Here's the flip side of the fees, though. ETFs have lower fees than mutual funds--a bit lower than unmanaged index mutual funds like those of Vanguard, and significantly lower than actively-managed mutual funds. So, a point for ETFs.

Taxes

ETFs are winners in the tax game over mutual funds, and I'll try to explain why, but I'm not an accountant. so bear with me.

Mutual funds are literally a basket of stocks owned by the mutual fund company. If a mutual fund is actively managed, you may have capital gains throughout the year as profitable stocks are sold within the fund. In addition, if the fund has a lot of redemptions from other fund shareholders, the fund may be forced to sell more stocks in order to hand over the cash to those shareholders. This could force more capital gains to be realized--and you'll have to pay the taxes on these.

An ETF, as I've mentioned a million times now, is like a stock, and, for the most part will only throw off capital gains when you actually sell that ETF in the open market, just like any other stock. Buy the ETF at $15.20, sell it at $16.00 a year later and pay capital gains on the $0.80 per share the stock has gained.

ETFs do have a little bit of trading within them in order to stay true to the underlying premise of the fund--if you have an S&P SPDR and the S&P changed its makeup by letting some new companies in and booting others, there would have to be some buying and selling within the fund in order to make sure it's made up of the right S&P components. So you could have some small capital gains to deal with, but usually much smaller than a mutual fund, especially an actively-managed mutual fund.

Conclusion

I don't see any advantage for the average investor in buying ETFs versus regular mutual funds. The commissions on purchases and sales hurt your earnings, and the lower fees and capital gains are not enough to change the equation. You'd be better off buying an index mutual fund, which might have ever-so-slightly higher fees, but wouldn't charge you a commission and would let you make ongoing contributions without charge.

If you're a very active investor or are really interested in hitting a narrow sector of the market--say, all aerospace stocks--that you don't feel is adequately represented in available mutual funds, I could see the attraction of ETFs. But for as often as I see them mentioned in the financial media, I have to say--I don't get it.

I'm sticking with the KISS principle here and steering clear of ETFs. If you have a differing opinion or I haven't described something correctly in my analysis, please let me know.