Exchange-traded funds, or ETFs, are index funds that trade like stocks. In other words, they can be bought or sold throughout the trading day, unlike mutual funds, which change hands only at the end of the trading day. There are a variety of ETFs currently available including SPDRs, HOLDRs, iShares, Qubes and Diamonds. They are passively managed, and track a wide range of broad-market, sector-specific, and country-specific indexes.

The main advantage of ETFs is that they typically have lower expenses than even the cheapest index mutual funds. For example, the annual expense ratio of the iShares S&P 500 Index Fund is 0.09%, compared to 0.18% for the Vanguard 500 Index Fund. ETFs are also more tax-efficient than conventional mutual funds. These advantages are only realized by using a buy-and-hold strategy. Investors who trade in and out of ETFs on a short-term basis can generate substantial trading costs and poor tax efficiency.

At Shearwater Capital, we use ETFs mainly for fine-tuning a portfolio's asset class allocation. If a client portfolio is underweighted in a particular market sector, ETFs are an excellent tool for improving portfolio balance and diversification.

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