High commissions and management fees, along with taxes, can really cut into your returns.
That's where exchange-traded funds, or ETFs, come in. In today's investment world, ETFs are cheaper and more tax-friendly than mutual funds.
The average expense ratio for US-listed ETFs is 0.4%, compared with 1.42% for diversified US stock funds. They also give you exposure to an entire industry or market with the click of a mouse.
It's one of the reasons why exchange-traded funds are quickly becoming the investment of choice for investors seeking broad market exposure.
In fact, the number of ETFs has surged over 10-fold in the last decade.
The total number of ETFs in the market grew to 1,114 by October 2011, with assets over $1 trillion, according to the Investment Company Institute.
And the ETF market will expand to roughly $3.1 trillion by 2016, according to projections from the Financial Research Corp. in Boston.
So if you're looking to diversify your portfolio and save money doing it, ETFs may be the way to go.
Here's a primer on how ETFs can work for you.
ETFs Trade like Stocks
The beauty of ETFs is that they are easy to buy and sell. All you need is a brokerage account. And for the most part, they are liquid and trade openly during market hours.
You can buy or sell ETFs throughout the day and set price and time limits. So if the market is plunging at noon and you decide to sell, you can sell at the market price, in an instant.
This is a huge advantage over mutual funds, where you can only buy or sell at the end of the day. If you sell a mutual fund and the market continues to fall, you will receive whatever price the fund falls to at the market close.
ETFs are baskets of securities that track a wide variety of investment classes, such as US and international stocks, precious metals, commodities, bonds and currencies.
They usually use a so-called passive management approach to track a particular stock market index, with the goal of matching that index's performance.
An ETF consists of the same equities as the index it tracks, although it may not contain all the equities in that particular index. But it will contain enough of them so that it will reflect the direction and price of the index.
Keep in mind that while an ETF is similar to its underlying index, it's designed to mimic the index, not outperform it.
However, other ETFs are leveraged to double or triple the return of an index. Still others allow investors to profit from market downturns by shorting the indexes.
Why Buy an ETF?
One major benefit of an ETF is that they are more tax efficient than a mutual fund.
Every time the assets in a mutual fund are sold at a profit, Uncle Sam takes a cut in the form of a capital gains tax. With ETFs those gains are not realized until the entire investment is sold. So you'll be paying capital gains taxes less frequently.
ETFs can also save you money on trading commissions.
If you're trying to buy an index of stocks, you pay a commission on each transaction. ETFs pre-package the equities for you in one tidy bundle-all in one trade, at one price, for one commission.
And remember, ETFs also charge less in management fees than mutual funds.
You can use an ETF either to get exposure to a market or industry, or hedge your risk against too much exposure.
For instance, you might feel you have too much exposure to Europe and Japan and not enough to China and Brazil. You could hedge against that risk with the Vanguard MSCI Emerging Markets ETF (NYSE: VWO).
Your investment horizon is also an important consideration. You can buy leveraged ETFs to protect against short-term downturns, or you can hold standard ETFs for long-term gains.
After you've decided which market you want to buy (or sell) you should lean towards the lowest cost ETFs in that category, according to Forbes.
"Let's assume you have picked the category you want exposure to...Then three things matter: costs, costs and costs," columnist William Baldwin recently wrote referring to ETFs.
Forbes ranked the four best buys in each of 11 categories, assuming a three-year holding period.
A few of the top-ranked ETFs with broad exposure to markets include: Vanguard Total Stock Market ETF (NYSEArca: VTI), the iShares Gold Trust (NYSEArca: IAU), the PIMCO 1-3 Year US Treasury Index Fund (NYSEArca: TUZ), and the Vanguard FTSE All-World ex-US ETF (NYSE: VEU).
These are just a few of the hundreds of ETFs that can reduce your trading costs and improve the performance of your investment portfolio.
Don Miller is a contributing writer with Money Morning.