By Deborah Peri and Steve Lewis

Exchange Traded Funds (ETFs) have exploded in popularity. Actively managed mutual funds, over the past five years, have grown from $7 trillion to $8.2 trillion, a 17 percent increase. Exchange Traded Funds, however, have grown from a modest $65.6 billion to $243 billion, a 270 percent increase. Mutual fund companies may have more assets but are worried about this significant trend.

Most ETFs are index funds, which means they hold a basket of securities like the 500 stocks that make up the Standard & Poor’s 500 index. Since the basket doesn’t change frequently, ETFs have low annual expenses (maybe 0.20 percent compared with 1.50 percent), and much lower tax implications compared to most mutual funds.

ETFs tend to perform better than most mutual funds since about 85 percent of the mutual funds don’t even match the market.

Because ETFs are index funds, and the investor knows what stocks or bonds the index represents, the investor can build a custom portfolio. For example, if one’s portfolio is a little light in small company growth stocks, the investor can fill the gap easily with the iShares Russell 2000 Growth ETF fund. One can purchase portfolios in real estate, energy, utilities or high-tech issues, for example. It is more difficult to fill in a gap with an actively managed fund. For example, a large-cap growth manager may decide to buy mid-cap value issues if he favors these and the prospectus gives him the latitude. The investor believes he is buying one thing, when he is actually getting something quite different.

ETFs free the investor from worrying about other shareholders’ actions. If many investors decide to sell their shares at the same time, a mutual fund may not have enough cash on hand to pay for all the redemptions. This may cause them to sell some securities they would rather not, forcing share prices down. ETFs, however, trade like a stock on an exchange. One buys or sells to and from another investor. This has no effect on the internal portfolio.

Because ETFs trade on exchanges, the investor can buy and sell shares continuously, unlike mutual funds which price their shares once per day. This allows stop-loss orders or even short ETF shares to capitalize on a declining market.

ETFs, of course, have disadvantages. The main one is that investors need to pay more attention to ETFs than mutual funds. With ETFs there is no manager trimming overvalued securities, so market fluctuations may have an exaggerated effect.

Also, since ETFs are built to mimic the averages it will be virtually impossible for the investor to beat the market, unless techniques are employed beyond the scope of this article.

The dividends paid by ETFs do not automatically reinvest - the investor must decide what to do with them. Because the investor pays a commission to buy ETFs, he will also pay a commission to reinvest and to rebalance periodically. This may deter the investor from reinvesting and rebalancing - crucial components of successful investing.

Many believe that ETFs should not be an all or nothing proposition. Balancing index ETFs and active mutual funds along with other investments, while understanding how they all behave in different environments, can help build a stronger financial strategy.

Steve Lewis, a Los Altos Hills resident, is president of Lewis & Mathews, Menlo Park. Deborah Peri is vice president, Curran & Lewis, Menlo Park.