Exchange-Traded Funds (ETFs) are similar to index funds, except they can be traded like a stock on stock exchanges, and you must buy them through a brokerage firm.

ETFs are required to maintain a 99 percent correlation to their designated benchmark. There are many different indexes used as benchmarks, so be sure to understand how the ETF is being judged.

ETFs have exploded in recent years: there are now more than 700 of them, and investors have poured over $790 billion into them. Should you join the ETF frenzy?

I don’t think so.

The lure of ETFs is that you can buy so many different slices of the markets. There’s an ETF that invests in cancer research stocks and another that tracks the maritime shipping industry. The problem is the wide array of ETFs tempts investors to guess which segments of the market will outperform other areas. There’s no data indicating anyone has this ability.

Disadvantages of Buying ETFs

It’s not just that ETFs seduce investors into thinking they can predict the market. There are a number of reasons ETFs are not a smart investment choice:

Transaction Costs: Buyers of ETFs seem unable to resist the temptation to trade them like stocks. In 2009, ETF assets turned over a remarkable 23 times. The purpose of ETFs and index funds is to buy and hold them for the long term. By trading ETFs, investors run up transaction costs, which reduce returns.

Brokerage Commissions: The brokerage commissions you have to pay to buy and sell ETFs further reduce your returns. With index funds, you buy directly from the fund family (like Fidelity or Vanguard). You don’t pay any commissions.

Difference in Market Price: You also have to pay what’s known as the “bid-ask spread” when you buy shares in an ETF. There’s a gap between the market price for buying the ETF and selling it. For example, if the bid price is $40 and the ask price is $41.50, the bid-ask spread is $1.50. As a buyer, you will pay the ask price. The seller receives the bid price. The broker pockets the difference. Index fund purchasers do not incur this charge.

Inconvenience: Index funds permit you to automatically invest dividends back in the funds. Dividends from ETFs pay distributions in cash. You then have to figure out how to invest them.

Brokerage Dependence: I don’t like any investment that requires you to deal with a broker. Inevitably, you will get a cold call extolling the services of the brokerage firm. They will tell you how they can “beat the markets” by picking stocks that will outperform other stocks, or by selecting the next “hot” mutual fund manager. Almost every call I get from distressed investors begins with a tale of woe about how their broker caused them harm. No one has the skills brokers claim to have. Therefore, I tell everyone I know to stay away from them. Buying ETFs gets you too close to the flame.

Consider Index Funds Instead of ETFs

Investors would be far better served by purchasing low-cost index funds that track the entire domestic and international stock markets and the investment-grade U.S. bond market. Examples of these funds are Vanguard’s Total Stock Market Index Fund (VTSMX) (domestic stock market), Total International Stock Index Fund (VGTSX) (international stock market), and Total Bond Market Index Fund (VBMFX) (domestic bond market).

Dan Solin is a Senior Vice-President of Index Funds Advisors. He is the author of the New York Times best sellers The Smartest Investment Book You’ll Ever Read, The Smartest 401(k) Book You’ll Ever Read, and The Smartest Retirement Book You’ll Ever Read. . His latest book is Timeless Investment Advice.

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