Although exchange-traded funds (ETFs) aren’t new to the investment world, their recent growth in the industry has truly become a phenomenon. But just what is an ETF, and how did they get started? And, more importantly, how can you use them in your portfolio?

ETFs are equity funds that track a specific market index, yet can be traded like a stock. They are essentially a basket of securities that make up a given index, such as the S&P 500 (SPX). In fact, the first ETF ever issued was the Standard and Poor’s Deposit Receipt, or the SPDR S&P 500 (SPY), which began trading in 1993.

The great thing about ETFs is that they are much more tax-efficient than traditional mutual funds, as there is virtually no internal buying and selling going on in an index. And because they track an index, their expense ratios and transaction costs also are quite low. Plus, there are no sales loads charged for ETFs.

Freedom of Choice, Is What You Got

Perhaps the best thing about ETFs, particularly in the last few years, is the immense diversity they offer the individual investor. Investors can gain exposure to just about any sector of the market using ETFs — domestic equities, foreign equities, emerging markets, bonds, inverse bond funds, commodities and currencies.

One of the things I love about ETFs is that you can use them for your long-term investments and your short-term “mad money.” In fact, just about any philosophy, trading style or trading system shy of sophisticated options plays, will likely be well served via ETFs.

Like the Cambrian Explosion

To say that there’s been an expansion in the number of ETFs that have come to market during the past several years is the height of understatement. A better way to get a sense of the growth in the ETF market is to liken it to the Cambrian explosion, the period dating about 500 million years ago where scientists discovered the seemingly rapid appearance of most major groups of complex animal life on earth.

According to my latest tally, there are more than 800 ETFs (including their cousins, exchange-traded notes or ETNs) trading in the market today.

Vast and Far-reaching

You’ll find numerous ETFs offering exposure to dividend equities, growth equities, bonds, specific country indices, currencies, bear market or so-called inverse funds, and global sectors. There are even a few actively managed ETFs on the market.

Oh, and don’t forget about ETFs that represent the various market sectors such as financials, health care, energy, real estate, basic materials, consumer cyclicals, technology, utilities — well, I think you get the point. And there are multiple ETFs within many of these sectors.

Pick Your Poison

Now that you know investing with ETFs gives you the flexibility and freedom to choose just about any sector you want, the question now becomes how do you decide which ETF is best suited for your portfolio? And while this is a question that nobody but you can answer, I can give you some general guidelines on what to look for when choosing the right ETF.

First off, whether you’re a trader or more of a long-term investor, you always want to buy the more heavily traded ETF. In other words, when faced with a choice of ETFs that fit your objectives, I always like to buy the one with the most liquidity. By doing so you’ll be able to get out of the position quicker — and likely at a better price — if things turn against you.

Limit the Leverage

The use of leverage in ETFs is all the rage these days. But like options trading, if you don’t know what you’re doing, you could end up in big trouble. ETFs that employ double and even triple leverage are great ways to play a sector over very short time periods, i.e., several weeks at the most. But because these two, and particularly three times, levered ETFs require the use of various options to achieve their two- and three-beta performance objectives, they must constantly turn over various options contracts. This can be a tricky proposition, and over the long term it can lead to returns that fall short of the two- and three-time performance goals. Over the short run, however, these high-beta, levered funds are great, provided you know when to take your profits — or losses — and run.

Do Your Homework

Before you buy any ETF, you have to do your homework. You should know what stocks make up the ETF, what the percentage of each stock is held in the ETF, what and when any dividend distributions are made (if any), what the fund’s expense ratio is, whether the fund employs any kind of leverage to achieve its performance objective, and, of course, what index the fund tracks.

The old adage of caveat emptor, or “let the buyer beware,” should apply to every purchase you make, and ETFs are no exception.

Go Get ’em

Finally, if you want to be an informed and educated investor, then you have to put the necessary time in to become informed and educated.

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