By Erik Liik, President of FocusShares

When I'm asked what an exchange-traded fund (ETF) is, my starting point is mutual funds. Most people know that mutual funds invest in a broad range of securities - stocks, bonds, commodities and other financial instruments. ETFs operate the same way.

The similarities between ETFs and mutual funds aren't coincidental. Most, but not all, ETFs owe their existence to the same federal securities law that long ago gave rise to mutual funds. So at their core, exchange-traded funds and mutual funds are investment siblings.

However, the differences between the two are significant and investors should understand them well.

Shares

Mutual funds buy and sell shares directly to the public. They create shares as new money flows into the funds. ETF shares are purchased by the public through brokerages. When demand grows, market specialists - not the ETF company - create new shares. Those same specialists reduce shares when demand falls.

Trading Shares

Mutual fund shares can only be purchased at the net asset value (NAV) at the end of a trading day. Exchange-traded funds can be traded throughout the day at prices determined by investors. Typically, that price is close to the NAV of the ETF.

Investment Philosophy

The vast majority of ETFs rely on index investing, meaning they purchase stocks that make up indexes, such as the Morningstar^TM Large Cap Index or the S&P 500. Most ETFs attempt to match market returns, minus fees. Most mutual funds are actively managed, which means they hire managers in an attempt to beat the market returns.

Capital Gains Distributions

Both exchange-traded funds and mutual funds can pay capital gains distributions - which may be taxable events for investors. However, according to IndexUniverse, the vast majority of ETFs have never paid a capital gains distributions (partly because of their structure), while most mutual funds pay them regularly.

Expense Ratio

Because many mutual funds hire managers, these mutual funds tend to have higher expense ratios than ETFs. According to Lipper, Inc., the average stock mutual fund has an expense ratio of 1.15 percent. The average ETF was 0.53 percent. Expense ratios act as a drag on performance.

Transparency

Daily, ETFs are required to publish the precise securities held and in what percentages. Mutual funds usually publish their holdings' lists quarterly.

So what does all of that mean? ETFs can be a powerful tool for any investor. Active traders have long been drawn to ETFs because they can be traded continuously throughout the day. Buy-and-hold investors tend to like ETFs because of their low fees, their transparency and their tax efficiency.

The fact that ETFS must be purchased through brokerages has been a drawback for investors who want to rebalance or dollar-cost average small sums. Commissions can take a sizeable chunk out of those strategies. That's been somewhat alleviated because a handful of brokerages now offer commission-free trading of ETFs. Focus Morningstar^TM ETFs can be purchased commission-free online by Scottrade customers.

Like any investment vehicle, mutual funds and ETFs are not necessarily built for everyone. Many come with major risks of investment loss. So, make it a point to educate yourself about ETFs and mutual funds before you buy shares.

Erik Liik is the president and CEO of FocusShares LLC, a subsidiary of Scottrade based in Montvale, N.J. FocusShares offers 15 domestic equity exchange-traded funds. For more information on FocusShares go to www.focusshares.com

Consider the investment objectives, charges, expenses, and risks of an ETF or mutual fund carefully before investing. A prospectus containing this and other information should be obtained from the issuer. The prospectus should be read carefully before investing. Focus™ Morningstar ETFs are commission free for those using Scottrade's online platforms. Investors not affiliated with Scottrade are subject to commission costs. Morningstar is a service mark of Morningstar, Inc. and has been licensed for use for certain purposes by FocusShares, LLC (an affiliate of Scottrade, Inc.). The Focus™ Morningstar ETFs are not sponsored, endorsed, sold or promoted by Morningstar, and Morningstar makes no representation regarding the advisability of investing in Focus™ Morningstar ETFs.