For many years, investors have attempted to diversify their overall portfolios by trying to pick stocks across a diverse set of asset classes. Which is all well and good, but the problem it generally runs into is you should also be diversified within any given asset class, lest something adverse happen to the company you happened to bet on. Yet as soon as your diversifying both within, and between asset classes, now your running a portfolio of potentially 40+ equities, and even the active investor rarely has time to do due diligence on the hundreds of companies required to find 40 excellent investments.

ETF. The latest all important acronym to add to your vocabulary. ETF stands for exchange traded fund; a relatively recent innovation that allows investors to directly target sectors for investment, instead of picking individual stocks, and praying those stocks wont underperform their sector. ETFs are similar to mutual funds, with a couple important differences. They can be bought and sold like a stock, no minimum investment or redemption fees, and you can short them.

The purpose of an ETF is to allow an investor to purchase a single equity that represents an investment in a sector. So if an investor is interested in buying financial stocks, they could buy XLF. If they want some small cap goodies, they can choose to buy IWM. For some exposure to the Chinese stock market, they could invest in FXI. Finally, if they simply want to emulate the returns of the S&P 500 index, the SPY has them covered.

But why shun the mutual fund? Why take the new guy over the established king? Lets start with the tax advantage. When mutual funds endure large sell offs, they have to liquidate many positions, some of which are currently at a gain. They then have to pay capital gains on those positions, and this negatively impacts their return. It would be an understatement to say that Mutual funds generally have higher expense ratios in general compared to ETFs. It can sometimes cost as little as 8 dollars to get into an ETF whereas a mutual fund of 20,000 that grows to 60,000 over a 20 year period may have conservatively lost as much as 18,000 to its competent managers.

Of course, the vast convenience ETFs have over mutual funds shouldn’t be underestimated. ETFs can be traded just like a stock, giving active traders the ability to buy and sell intraday. The ability to short was impossible with a mutual fund, but now it can be done. During any bear market, the ability to benefit from the fall of sectors as well as their rise is a valuable one to have.

Another important consideration is that most of the more liquid ETFs are optionable. This means that option-savvy investors can harness the power of stock options to change the risk-reward profile of their positions, and risk-conscious investors can use stratagems such as the covered call and protective put to protect their investment.

There are some disadvantages to ETFs as well. Some ETFs have complex structures that can lead them to deviate from what they are supposed to be tracking. A similar instrument, ETNs, can also easily be mistaken for an ETF, leading to some general confusion about what exactly you are investing in. Yet for those willing to put in the work to learn, ETFs can be a highly profitable venture for the modern day portfolio.

ETFs are a diverse tool that allows one to remove risk from ones portfolio by investing in sectors instead of individual companies. They allow investors to benefit from downturns in markets as well as the uptrends. And they allow the investor to take advantage of options on sectors, which options-savvy investors can use to supercharge returns. Given their great variety of uses, ETFs should be a valued part of any investors portfolio, to be ignored at the investors peril.