Exchange-traded funds (ETFs) are turning into the "next big thing" in many investment circles. And investors and traders are catching on as they turn to ETFs as an alternative to index or mutual funds.

Just look at the numbers at the end of July. There was $578 billion in ETFs versus $12 trillion in mutual funds, but the momentum is shifting. In fact, seven of the 10 best-selling funds in July were ETFs.

The extreme volatility that has come to the market recently is making them even more attractive plays for anyone who wants to keep up with the latest investment trends.

Let’s look at five ETF advantages to discover why these instruments are making waves and why more investors are adding them to their portfolios.

Cover All The Bases

ETFs give traders a way to make smart plays in a sector, rather than trying to pick individual stocks and hoping to choose the right ones.

In fact, this is a way to quickly build a portfolio because there are ETFs covering every major index, asset class and niche an investor can imagine.

Even commodities such as gold and oil are also covered by ETFs.

For example, you might not know which retailers are going to spike in front of a holiday rally (or which ones are going to drop when everyone scales back on their spending), but you can trade shares in an ETF like the Amex SPDR Retail ETF (XRT) to cover your bases in that sector.

You are probably thinking to yourself that you can do this in index and mutual funds, but ETFs have a unique advantage.

Flexibility: ETFs are Like Mutual Funds, Only Better

When you buy a mutual fund, you can only buy at one price daily after the net asset value (NAV) of the fund is calculated. But what do you do if a game-changing event happens during the session?

In a mutual fund, you’re trapped because you can’t leave the stock intraday. The NAV of the fund is calculated at the end of the business day, so you are stuck with that price and the implications of whatever movements occurred during the session.

ETFs give you the advantage of mirroring sectors and indexes, but they trade like stocks, so you can shift positions during the day. In today’s markets with increased volatility, the ability to capture short-term movements can make the difference between a good day and a bad one.

But suppose you want to ramp up your gains

You Have Options

Want to buy an option on a mutual fund to leverage your position? Forget about it, you can’t do it.

ETFs function just like a stock, because they represent a collection of individual stocks in a single sector. Accordingly, you can trade calls and puts on them to take advantage of movements in that particular sector.

For example, you could buy calls on the Amex SPDR Retail ETF mentioned earlier if you believe holiday spending is going to explode, or you can buy puts on it you’re less optimistic due to the recession.

One difference with ETF options and equity options is that they trade in $1 increments, and they are only available during select months of the current year. Your broker can point you in the direction of optionable ETFs.

Invest For Less

Have you ever looked at your mutual fund statement and wondered why there are so many fees? Sometimes management and operating fees and commissions are taken out of your mutual fund investment before any shares are purchased. What’s that all about?

These fees are designed to help reduce turnover in the fund, but they also reduce the power of your investment. ETFs, on the other hand, have lower expense ratios than index and mutual funds, so they’ll have more funds to invest. Your expenses are based on the commissions you pay for your trades. And there are plenty of places to make trades online for $10-$15 per transaction.

In addition, you’ll make fewer trades by using ETFs to invest that you would if you tried to cover a sector by purchasing individual stocks. Remember, you’re grabbing multiple stocks at once by buying the funds, which means you’re racking up less fees.

Easy Asset Allocation

One of the best ways to make profits and protect your investments is to make sure you can adjust your portfolio for changing market conditions and trends.

During different stages of life, investors have different needs and risk levels, and they need an easy way diversify their holdings. Investors are often advised to spread their investments across several asset classes including stocks, bonds, real estate and cash.

ETFs can’t help you with your cash, but they can give you a way to rotate in and out of sectors quickly, as situations warrant. And it’s easy to make these changes with minimal expense using ETFs.

Younger investors can use ETFs to catch rising sectors without trying to grab the right stock at the right time, and older investors can use them to diversify their investments across a wider range of investments with a smaller hit to their funds in the form of fees.