By Russell Wild

An exchange-traded fund (ETF) is something of a cross between an index mutual fund and a stock. Because ETFs are relatively new to investors, they have a lot of questions.

Are ETFs appropriate for individual investors?

You bet they are. Although the name exchange-traded funds sounds highly technical and maybe a little bit scary, ETFs are essentially friendly index mutual funds with a few spicy perks. They are more than appropriate for individual investors. In fact, given the low expense ratios and high tax efficiency of most ETFs, as well as the ease with which you can use them to construct a diversified portfolio, these babies can be the perfect building blocks for just about any individual investor’s portfolio.

Are ETFs risky?

That all depends.

Some ETFs are way riskier than others. It’s a question of what kind of ETF you’re talking about. Most ETFs track stock indexes, and some of those stock indexes can be extremely volatile, such as individual sectors of the U.S. economy (technology, energy, defense and aerospace, and so on) or the stock markets of emerging-market nations. Other ETFs track broader segments of the U.S. stock market, such as the S&P 500. Those can be volatile, too, but less so. Commodity ETFs can be more jumpy than stocks.

But other ETFs track bond indexes. Those tend to be considerably less volatile (and less potentially rewarding) than stock ETFs. One ETF (ticker symbol SHY) tracks short-term Treasury bonds, and as such is only a little bit more volatile than a money market fund.

Many of the newer generation ETFs are leveraged, using borrowed money or financial derivatives to increase volatility (and potential performance). Those leveraged ETFs can be so wildly volatile that you are taking on risk of Las Vegas proportions.

Do you need a financial professional to set up and monitor an ETF portfolio?

Do you need an auto mechanic to service your car? It depends on both your particular skills and your inclination to spend a Sunday afternoon getting greasy under the hood. Setting up a decent ETF portfolio is very doable. You can certainly monitor such a portfolio as well.

A professional, however, has special tools and objectivity to help you understand investment risk and construct a portfolio that fits you like a glove, or at least a sock. A financial planner can also help you properly estimate your retirement needs and plan your savings accordingly.

Do be aware that many investment “advisors” out there are nothing more than salespeople in disguise. Don’t be at all surprised if you bump into a few who express their disgust of ETFs! ETFs make no money for those salespeople, who make their living hawking expensive (often inferior) investment products.

Your best bet for good advice is to find a fee-only (takes no commissions) financial planner. If you are more or less a do-it-yourselfer but simply wish for a little guidance, try to find a fee-only planner who will work with you on an hourly basis.

How much money do you need to invest in ETFs?

You can buy one share of any number of ETFs for as low as the price of a share. But since you usually pay a commission to trade (the average trading commission is about $10), buying one $20 share (and thus paying a 50 percent commission) would hardly make good sense. Starting at about $3,000 perhaps, it may be worth investing in ETFs, but only if you plan to keep that money invested for at least several years. Smaller amounts are perhaps better invested in mutual funds (preferably low-cost index mutual funds), money markets, or other instruments that incur no trading costs.

If you wish to invest in an ETF at a brokerage house that doesn’t charge trading commissions for that particular ETF (Vanguard, for example, doesn’t charge you to trade Vanguard ETFs; and Charles Schwab doesn’t charge you to trade Schwab ETFs), then you can buy one share at a time with impunity.

With hundreds of ETFs to choose from, where do you start?

The answer depends on your objective. If you are looking to round out an existing portfolio of stocks or mutual funds, your ETF should complement that. Your goal is always to have a well-diversified collection of investments. If you are starting to build a portfolio, you want to make sure to include stocks and bonds and to diversify within those two broad asset classes.

There is not much in the world of stocks, bonds, and commodities that can’t be satisfied with ETFs. Try to have both U.S. and international stock ETFs. And within the U.S. stock arena, aim to have large cap growth, small cap growth, large cap value, and small cap value. You can also diversify your stock ETFs by industry sector: consumer staples, energy, financials, and so on. Generally, don’t attempt to use separate ETFs to accomplish both grid diversification and sector diversification; doing so would require an unwieldy number of holdings.

Where is the best place for you to buy ETFs?

Set up an account with a financial supermarket such as Fidelity, Vanguard, T. Rowe Price, Schwab, or TD Ameritrade. Each of these allows you to hold ETFs, along with other investments — such as mutual funds or individual stocks and bonds — in one account. (You probably don’t need or want individual securities.)

Different financial supermarkets offer different services and charge different prices depending on how much you have to invest, how often you trade, and whether you do everything online or by phone. You need to do some shopping around to find the brokerage house that works best for you.

Is there an especially good or bad time to buy ETFs?

Nope, not really, at least not that can be determined in advance. Studies show rather conclusively that the stock and bond markets (or any segment of the stock or bond markets) is just about as likely to go up after a good day as it is after a bad day (week, month, year, or any other piece of the calendar). Trying to time the market tends to be a fool’s game — or, just as often, a game that some like to play with other people’s money.

Do ETFs have any disadvantages?

Because most ETFs follow an index, you probably won’t see your ETF (or any of your index mutual funds) winding up number one on Wise Money magazine’s list of Top Funds for the Year. (But you probably won’t find any of your ETFs at the bottom of such a list, either.) The bigger disadvantage of ETFs — compared with mutual funds — is the cost of trading them, although that cost should be minimal.

Building a well-diversified portfolio of ETFs — stocks, bonds, large cap, small cap, U.S., international — may also seem to have the disadvantage that in any given year, some of your ETFs are going to do poorly. Just remember that next year those particular investments, the ones that look so disgustingly dull (or worse) right now, may be the shiniest things in your portfolio.

Does it matter which exchange your ETF is traded on?

No. Most ETFs are traded on the NYSE Arca (Archipelago) exchange, but plenty of others are traded on the NASDAQ. It doesn’t matter in the slightest to you, the individual investor. The cost of your trade is determined by the brokerage house you use.

The spread (the difference between the price a buyer pays and the price the seller receives) is determined in large part by the share volume of the ETF being traded. Regardless of the exchange, if the volume is small (such as would be the case for, say, the Global X Nigeria ETF), you may want to place a limit order rather than a market order.

Which ETFs are best in your IRA, and which are best in your taxable account?

Generally, investments that generate income — whether interest, dividends, or capital gains — are best kept in a tax-advantaged retirement account, such as your IRA or 401(k) plan. That would include any bond, REIT, or high-dividend paying ETF. You’ll eventually need to pay income tax on any money you withdraw from those accounts, but it is generally better to pay later than sooner.

In the case of a Roth IRA, which is often the best case of all, you will never have to pay taxes on the earnings, the principal, what is in the account, or what you withdraw. Try to put your ETFs that have the greatest potential for growth — REIT ETFs are great candidates — into your Roth IRA.

Because retirement accounts generally penalize you if you take money out before age 59-1/2, anyone younger than that would want to keep all emergency money in a non-retirement account.