Qubes. StreetTracks. HOLDRs. Names of popular rock groups? Not even close. They’re all investments called exchange-traded funds (ETFs) and many people use them to build a diversified portfolio. Maybe you should, too — if you understand the risk/reward trade-offs.

An ETF is a basket of securities, shares of which are sold on an exchange, such as the American Stock Exchange. They combine features and potential benefits of stocks, mutual funds, or bonds. Like individual stocks, ETF shares are traded throughout the day at prices that change based on supply and demand. Like mutual fund shares, ETF shares represent partial ownership of a portfolio that’s assembled by professional managers.

Types of ETFs

There are a number of ETFs, each with a different investment focus. Following are some common types of ETFs.

• Diamonds follow the 30 large-cap companies that make up the Dow Jones Industrial Average.

• Standard & Poor’s Depositary Receipts (Spiders) mirror the S&P 500, an index of 500 of the largest companies in the United States. They also track select sectors of the S&P 500.

• iShares hold baskets of stocks in specific regions of the world, select countries, or sectors, or follow U.S. corporate or government bond securities.¹

• Qubes track the 100 largest businesses of the technology-driven Nasdaq Composite Index.

• StreetTracks replicate various indexes focused on sectors, countries, or investment style.¹

• Holding Company Depositary Receipts (HOLDRs) are ETFs with a twist. They usually focus on narrow, emerging sectors — companies building the Internet infrastructure, for example — and their baskets hold only about 20 stocks to begin with. Stocks will never be added, and over time a HOLDR’s basket can become even more concentrated, as stocks that are lost due to mergers aren’t replaced. HOLDRs also differ from most ETFs in that they only trade in lots of 100 shares and shareholders can exchange their shares for the underlying stocks at any time by paying a fee.

Investors should note that because many HOLDRs are narrowly focused, they can be more volatile than other types of ETFs. Also, HOLDR investors will receive annual reports and other investment-related information for each of the 20 stocks in their HOLDR basket. On the other hand, they’ll only pay one brokerage commission instead of 20.

Different Structures

Originally ETFs were organized as unit investment trusts (UITs). In a UIT, an investment company buys a fixed portfolio of securities and then sells shares of that portfolio to investors. This type of structure results in dividends being held in an interest-bearing account, which are deposited into the ETF once each quarter. The delay in investing dividends can have a slightly negative effect on the total return of the ETF because the dividends are held as cash instead of being invested. Spiders, Diamonds, and Qubes are all organized as unit investment trusts.

Other ETFs, such as iShares, Select Sector Spiders, and StreetTracks, are structured as open-end funds. This arrangement follows the typical mutual fund structure in that new shares are continually offered and redeemed by the investment company. An open-end structure allows dividends to be reinvested immediately.

Evaluating ETFs

These investments offer a number of potential advantages, including:

Tax efficiency – ETFs may be more tax efficient than some traditional mutual funds. A mutual fund manager may trade stocks to satisfy investor redemptions or to pursue the fund’s objectives. Selling shares may create taxable gains for the fund’s shareholders. Because ETFs are like stocks, redemptions aren’t an issue. In addition, managers of index-based ETFs only make trades to match changes in their index, which may mean greater tax efficiency.

Low expenses — ETFs that are passively managed (managers usually only trade shares to mirror underlying benchmarks) may have lower annual expenses than actively managed funds.

Flexible trading — Like stocks, ETFs are sold at real-time prices and trade throughout the day. Mutual funds, on the other hand, do not have this flexibility: Their pricing is based on end-of-day trading prices.

Can be sold short and bought on margin — Because ETFs trade like stocks, investors can use them in certain investment strategies, such as selling short and buying on margin. Traditional mutual funds do not allow shorting of stock or margin trading.

No minimum investment — Most mutual funds require a minimum investment, whereas an investor can usually purchase as few shares of most ETFs as desired.

Diversfication — An ETF may be a good way to add diversification to your portfolio. Buying shares of a technology sector ETF, for example, could potentially be less risky than purchasing shares of one technology stock — an ETF may own shares of many different technology companies.

Of course, as with all investments, ETFs may involve risks and other potential drawbacks. Consider these factors before investing:

The trading flexibility of ETFs may encourage frequent trading. That could lead to the possibility of mistiming the market (moving stocks in and out of the market at the wrong times).

Brokerage commissions are incurred. For this reason ETFs may be better suited for a buy-and-hold investor or someone who is buying a large number of shares at one time, rather than for an investor who uses a systematic investment program.

There may be capital gain distributions. At times some ETFs have distributed taxable capital gains usually because the managers have needed to buy or sell stocks to match their underlying benchmarks. Additionally, government bond ETFs are subject to federal income tax.

You should carefully consider the risks of different ETFs. Many sector ETFs, for instance, will tend to be more volatile than an ETF that tracks the broader market. Check with a financial professional to be sure that you understand the risks and have the most up-to-date information before investing in an ETF.

Points to Remember

1. Exchange-traded funds (ETFs) offer potential benefits and risks of both mutual funds, stocks, or bonds.

2. ETFs have different types of structures: Some are set up as unit investment trusts. Others are structured like open-end mutual funds, and dividends are continually reinvested.

3. Advantages of ETFs include potential tax efficiency, low expense ratios, flexible trading, and portfolio diversification.

4. Disadvantages of ETFs include occasional distribution of capital gains, brokerage commissions, and the potential for frequent trading, which could lead to mistiming the market.

5. ETFs may be better for a lump-sum investor with a long time horizon than someone who trades frequently and/or invests at regular intervals.

Investors in international securities are sometimes subject to somewhat higher taxation and higher currency risk, as well as less liquidity, compared with investors in domestic securities. Sector funds are subject to increased volatility due to their limited diversification compared with other stock funds.

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© 2011 McGraw-Hill Financial Communications. All rights reserved.

April 2011 — This column is provided through the Financial Planning Association, the membership organization for the financial planning community, and is brought to you by Martin V. Higgins, CFP, CLU, AEP , a local member of FPA.

One of the most effective financial tools you can give a child is an appreciation for an emergency fund and the advice on how to build it themselves.

An emergency fund should contain 3-6 months worth of money to cover living expenses – its main focus should cover all loss of income, not just a car payment or a refrigerator repair. With parents losing jobs and college expenses continuing to grow, the younger you can get a person started, the better. Some advice:

1. Start by encouraging them to save something, no matter how small the amount: Even if it’s a few cents out of an allowance, a teenager should be encouraged to set up a separate savings or checking account – someplace not easy to access – where they can house the money. Interest-bearing accounts are better. For young children, this is why piggy banks work so well. It’s about setting goals and knowing where the money is.

2. Help them develop a balance between treats and sacrifices: Financial independence requires a balance of risk and reward. Life can’t be all about building reserves, so tell the teen when they hit a certain level for the fund – maybe a midpoint toward the three-month mark – they can treat themselves to clothes or an electronic device. After the purchase, they go right back to saving.

3. Encourage them to direct all change into the emergency fund: No matter how old or young the child, it’s a good idea to take non-essential funds and direct them toward the emergency fund. Change is a great way to get started.

4. Set an example: Can your child see you saving? Do you physically set aside money and talk about goals for that money? Your child hears all of this. While parents can’t be perfect, think about the money behaviors you’re demonstrating in front of the kids, and try to make them positive.

5. Keep them away from credit as long as possible: It’s one thing for a teenager to use their parents’ credit card while they’re still living at home. It’s quite another when they get their first taste of freedom hundreds of miles away. Parents may co-sign the student’s credit card but keep it in the student’s name. That way, parents will know when financial missteps occur; this will be a strong incentive for the student to keep his credit rating clean for the next four years.

6. Set up money meetings: Whether the child is living at home or off at school, it makes sense for the parent and child to have a few meetings during the year to talk about the range of money issues the child is facing, and during that time, the emergency fund can be up for inspection and discussion.

7. Make them set up a real budget: Budgeting comes with saving. Young kids can do their first budget on paper – they can track what they spend and save over a month or two and then establish what comfortable amounts for both will be. Teenagers and prospective college students might find it useful to have personal finance software to track their everyday expenses, though they should make sure both the computer and the passwords necessary to access their program are secure.  Again, review these details during your money meetings.

8. Get them interested in better-paying, safe savings vehicles: At some point, the piggy bank’s got to go. An emergency fund can eventually gravitate to other interest-bearing accounts that might pay more, but only as long as the money stays liquid. If the emergency fund is healthy, it’s also wise for parents to talk to their children about setting up their first IRAs to get a jump on retirement planning and considerable tax savings.

9. Remind them that today’s emergency fund may not fit next year’s needs: An emergency fund will almost always need to expand in size as the person ages. More years, more expenses, more emergencies – make time to convince your child that emergency funds should change with life circumstances.

10. Train them to start saving tax refunds: If Uncle Sam kicks back a few bucks, then by all means, put it in the emergency fund or other savings vehicles.

January 2010 — This column is produced by the Financial Planning Association, the membership organization for the financial planning community, and is provided by Martin V. Higgins, CFP, CLU, AEP,  a local member of FPA.