ETF, or exchange-traded fund, has many benefits.

Think of an exchange-traded fund as a mutual fund that trades like a stock. Just like an index fund, an ETF represents a basket of stocks that reflect an index such as the S&P 500. (To read more on this subject, see our Index Investing tutorial.) An ETF, however, isn't a mutual fund; it trades just like any other company on a stock exchange. Unlike a mutual fund that has its net-asset value (NAV) calculated at the end of each trading day, an ETF's price changes throughout the day, fluctuating with supply and demand. It is important to remember that while ETFs attempt to replicate the return on indexes, there is no guarantee that they will do so exactly. It is not uncommon to see a 1% or more difference between the actual index's year-end return and that of an ETF.

By owning an ETF, you get the diversification of an index fund plus the flexibility of a stock. Because ETFs trade like stocks, you can short sell them, buy them on margin and purchase as little as one share. Another advantage is that the expense ratios of most ETFs are lower than that of the average mutual fund. When buying and selling ETFs, you pay your broker the same commission that you'd pay on any regular trade.