A decade ago, exchange-traded funds (ETFs) were few in number, and the average investor had never heard of them. Now, ETFs are fighting for — and winning — an increasing share of the investment pie. At last count, there were more than 400 ETFs trading on stock exchanges around the world.

What are they?

Some Canadian ETFs:

iShares CDN 60 Index Fund (TSX:XIU)

iShares CDN Gold Sector Index Fund (TSX:XGD)

iShares CDN Dividend Index Fund (TSX:XDV)

Claymore Oil Sands Sector ETF (TSX:CLO)

Exchange-traded funds, as the name suggests, trade on stock exchanges just like regular stocks. They pay dividends, just like stocks. But unlike stocks that track the fortunes of just one company, ETFs track an entire stock index or sector. This gives them the same benefits of diversification as a mutual fund, but in an investment that behaves like a stock. They are often referred to as "passive" investments, because there is no overall manager dictating which companies the ETF should buy or how much it should buy. The ETF is designed to automatically track the underlying index. No stock-picking debates here.

ETFs first appeared in North America in 1993 with the arrival of Standard & Poor's Depositary Receipts (AMEX:SPY). SPDRs (pronounced "spiders") track the S&P 500 index, which includes the biggest companies that trade in the United States. Since then, the ETF market has exploded with offerings that track other major indices like the Dow Jones Industrial Average (AMEX:DIA), the Nasdaq 100 composite index (NASDAQ:QQQQ), or the S&P/TSX 60 Index (TSX:XIU).

Newer ETFs track particular sectors within a larger index or even something that doesn't have a relevant index (like a recent U.S. offering that tracks companies where insiders have been accumulating shares). Some international ETFs track commodities or currencies.

What ETFs track Canadian markets?

ETFs known by other names:

"Spiders" (AMEX:SPY)

"Diamonds" (AMEX:DIA)

"Cubes" (NASDAQ:QQQQ)

The biggest Canadian ETF is the iShares (formerly iUnit) Canadian Large Cap 60 Index Fund (TSX:XIU), which was started in 1999 by Barclays Global Investors Canada, part of Britain's Barclays Bank. It has more than $8 billion of investors' money.

Barclays now runs 16 iShares ETFs for the Canadian market, including those that track the gold sector, financials, energy, tech, the income trust market and dividend-paying stocks. They also have ETFs that track bonds and a couple of foreign indices.

TD Asset Management used to offer four ETFs. But it exited the market in early 2006. State Street Canada's only Dow Jones Canada 40 Index ETF folded a few years before that. TD now concentrates on "e-funds" — low-fee index funds that are available only through the web.

Claymore Investments, an Illinois-based company, is a recent arrival on the Canadian ETF stage. It offers five ETFs, including some that provide exposure to Brazil, Russia, India and China (TSX:CBQ), Canadian blue chip value stocks (TSX:CRQ) and — new in October 2006 — the oilsands market (TSX:CLO).

Pros and cons of ETFs

Boosters cite the low cost of exchange-traded funds as one of their biggest selling features. They tend to carry much lower annual expense fees than mutual funds do. For example, the iShares 60 ETF has a management expense ratio (MER) of just 0.17 per cent. The typical Canadian index mutual fund has an MER of closer to one per cent. And most actively managed Canadian equity mutual funds (where the managers have the discretion to buy and sell whatever stocks they like) have MERs that cost more than two per cent annually.

Some quirky ETFs:

Homebuilders SPDR (AMEX:XHB)

Claymore/Sabrient Insider ETF (AMEX:NFO)

Claymore/Sabrient Stealth ETF (AMEX:STH)

PowerShares Dynamic MagniQuant Portfolio (AMEX:PIQ)

The cost comparison isn't completely fair, since someone who wants advice will have to shell out more money to find a full-service broker or a fee-only financial planner who is paid directly by the client. The higher annual MERs for mutual funds include the compensation your financial planner receives from the fund company in return for looking after your account. But for do-it-yourself investors, ETFs have proven to be a popular option.

ETF supporters also like their trading flexibility. ETFs can be bought or sold any time during the trading day, rather than just at day's end, like index or actively managed mutual funds. ETFs can also be bought on margin or can be sold short. Investors can also put in market limit orders to buy ETFs at a certain price; they can also put in stop orders to limit losses. U.S.-based ETFs can also be bought by Canadian investors. But there's no free trade in mutual funds. If the U.S.-based fund you'd love to buy hasn't been registered for sale in the Canadian market, you're out of luck.

ETFs also tend to be more tax-efficient, as they buy and sell stocks only when the underlying index changes. Some mutual funds turn over the entire fund's portfolio every year. That can trigger capital gains for fund holders. Of course, this isn't an issue in tax-deferred accounts like RRSPs or RRIFs.

Another ETF advantage over mutual funds has to do with transparency. When you buy most ETFs, you know exactly what you're buying. Most equity mutual funds, on the other hand, disclose their holdings only every one to three months.

ETFs become less of a bargain for those who want to invest a set amount of money each month. Since ETFs trade like stocks, they have the same commissions as stocks. That means that you'll pay every time you buy or sell. For someone who wants to invest $200 a month, it just doesn't make sense to pay a $25 commission every purchase. Those investors would be far better off to buy mutual funds through a financial advisor. The purchases can be structured so no commissions are paid up front, and many discount brokers and fund companies charge no redemption fees if the funds are held for a minimum period of time.

For those investors who want advice, they should be aware that their financial advisor may not sell them, or may not recommend them. For one thing, many advisors are licensed to sell mutual funds only. Since ETFs trade on stock exchanges, an advisor must be registered to sell securities. There's also the issue of compensation. Most advisors don't directly charge clients for their services. They're paid by fund companies through initial sales commissions (often five per cent for equity funds) and annual fees (called "trailers"). Most ETFs don't pay trailer fees (Claymore does offer adviser-class ETFs that pay trailers) and none pay five per cent commissions.

If you want investment advice and a portfolio that's loaded with ETFs, then you may have to find a full-service broker or a financial planner who's paid directly by you.

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