With nearly $450 billion in assets and growing, exchange-traded funds may be ready for their turn in the spotlight. The number of ETFs has grown from 80 at the end of 2000 to 737 at the start of 2009. Although these investment vehicles have entered the mainstream, some investors may feel that ETFs are shrouded in mystery.

Yet once you demystify them and understand how they work, you will be in a better position to determine whether exchange-traded funds may be appropriate for your portfolio.

What Is an ETF?

Exchange-traded funds are unique investments that resemble mutual funds in some ways and behave like stock in other ways. ETFs are baskets of securities put together by investment companies. They are usually assembled to track an index, sector, or other group of stocks.

Individual shares of ETFs are similar to individual shares of stock in that they can be traded, causing prices of those shares to fluctuate throughout each trading day. The prices of ETF shares tend to track the value of the underlying securities, although supply and demand for the shares themselves can affect share prices relative to the underlying securities. The principal value of exchange-traded funds will fluctuate with changes in market conditions. Shares, when sold, may be worth more or less than their original cost.

What Benefits Do ETFs Offer?

Because a single share of an ETF represents an entire portfolio of investments, ETFs offer a way to diversify that could be cost-prohibitive for investors to achieve by directly purchasing the underlying investments. Investors can use ETFs to target specific indexes, sectors, or types of securities to match their financial goals. Diversification does not eliminate the risk of investment losses; it is a method used to help manage investment risk.

Typically, ETFs are passively managed and, as a result, may offer lower expense ratios and greater tax efficiency than mutual funds. Also, there are no sales loads or minimum investment amounts associated with ETFs; however, investors usually need a broker to buy ETF shares and typically have to pay a commission.