In last week's issue of Financially Fit, we discussed how the advent of index funds has revolutionized investing for the individual investor who does not have the time required to create and maintain a balanced portfolio of individual stocks or mutual funds.

Today, I want to take indexing a step further, and talk with you about an expansion of the indexing idea - the creation of the exchange-traded fund (ETF) .

ETFs (exchange traded funds) were pioneered by the American Stock Exchange in 1993, with the development of their SPDRs ETF that tracks the S&P 500 (and now more than $50 billion in investments) , the ETF market currently stands at a whopping $265 billion, with more than 200 diverse ETFs available for investment!

Investors are finding ETFs much to their liking. But before I delve into the advantages of buying and holding ETFs, let me give you a brief explanation of this fairly recent investment vehicle, including how it differs from a mutual fund.

Almost any investor can tell you how a mutual fund works. A typical actively-managed fund collects cash from investors, pools it, and buys and sells different classes of investments. Many also charge hefty expenses, and after those are deducted, attempt to return some sort of appreciation and/or dividends to its fund holders.

Index funds are more passive, generally computer-driven, and try to duplicate the performance and investments of the index they are tracking. They typically have lower expense ratios than actively-managed funds due to less frequent trading and negligible if any investment in research.

From their inception, ETFs have been different -. They don't start with accumulated cash; instead, they typically begin life by gathering stocks already owned by major institutions into a pool, with the intention of tracking a particular index. The stocks are traded to the holding entity for a certain number of creation units. Therefore, the fund is created using stocks instead of dollars.

The creation unit consists of a large segment of shares of the ETF. Those are then divided into individual shares by the recipients. And those shares are then traded on the open market. More shares become available if the institutions give additional shares to the designated holder.

ETFs hold tremendous advantages over the average mutual fund:

• Expenses are significantly less than most mutual funds. For example, the least expensive ETF is iShares S&P 500 Index Fund (IVV) , with a mere .09% expense ratio. When was the last time you saw a mutual fund with such low expenses? Although you should know that sector ETFs do incur higher expenses than the broad market index ETFs. And trading in ETFs do require a broker, albeit, a commission. However, the total expenses (unless you are an active trader - and if that's the case - you shouldn't be in ETFs) , are, on average, much lower than the expenses of mutual funds investing in similar asset categories.
  
  
• Liquidity and transparency. ETFs can be traded all day long, instead of just once daily for mutual funds. With funds, you buy your shares at the end of the trading day, at the published net asset value (NAV) . ETFs are continuously priced throughout the day. You buy and sell them just like stocks. That means you can get in and out of the ETF market at your convenience - not the fund's. And unlike mutual funds, with ETFs, you can use limit orders; you can sell them short; and you can trade options.
  
  
• Less capital gains distributions. Investment turnover in ETFs is not as frequent as in mutual funds, lending themselves to lower capital gain distributions; hence, a smaller tax bite for most investors. Additionally, many mutual funds are forced to sell shares when they incur huge demand for redemptions (as the fund holders are selling their shares back to the mutual fund company) , triggering tax consequences. With ETFs, there is a buyer for every seller, so the ETF itself is, most likely, not going to rack up huge tax bills that may come back to haunt you at the end of the year.
  
  
• No minimum investment for ETFs. Unlike most mutual funds (unless in a retirement plan) , which will require a significant investment to start.

In 2005, ETFs spread their wings, creating vehicles for the gold and currency markets. And sector ETFs began mushrooming. For the future, you can expect to see more fixed income, international and commodity ETFs.

But continuing our focus from last week on the broad markets, you will find that it is very easy to invest in the broader market ETFs, including SPDRs (S&P 500) , DIA (Diamonds - Dow Jones 30 Industrials) , or QQQQ (NASDAQ 100 Trust) . The table below highlights some of the more popular broad market ETFs.

There are scores of ETFs - spanning small-, mid- and large-cap indices. In addition, you will also find numerous opportunities to invest, internationally, via ETFs. Here are a few more ETFs that you may find of interest:

Small cap:

• S&P 600 Value; iShares IJS
• Russell 2000 Value; iShares IWN
• MSCI US 1750 Value  Vanguard; VBR
• iShares Morningstar small value; JKL

Mid cap:

• Mid Cap SPDRs; MDY
• ishares Russell Midcap Index; IWR
• iShares Dow Jones Select Dividend Index; DVY

Emerging markets:

• iShares MSCI Emerging Mkts; EEM
• Vanguard Emerging Mkts VWO

For additional information on ETFs, their performance and expenses, these web sites are very helpful:

• http://screen.morningstar.com/etf/Lists/ETFStyleVolDescAllAll.html
• http://funds.reuters.com/lipper/retail/reuters/lipperperformingfunds.asp?type = etf
• http://finance.yahoo.com/etf

ETFs are an excellent way to diversify your portfolio, with minimal expenses. But they do have expenses - and as you can see from the above table - expense ratios can vary widely. We urge you to examine returns, as well as expenses, prior to making your investment decisions. And remember, ETFs trade like stocks, so please take into consideration your brokerage commissions, too.