An example: Let's say that at some juncture oil stocks collapse simply because a hedge fund blew up and had to sell its position. You figure oil stocks are really cheap, and you want to invest. Twenty years ago, before the arrival of exchange-traded funds, you would have had two choices: buy a mutual fund that invests only in oil companies, or buy individual oil stocks.
Both would be very expensive for the ordinary investor. The oil mutual fund would charge you a high upfront sales fee, plus heavy management expenses every month. A rip-off.
Meanwhile, buying individual stocks would be even worse. You would have to pay a trading fee on each one, so if you tried to buy a diversified basket, you would pay through the nose. And even with the best intentions in the world, you probably wouldn't end up fully diversified. No private investor could afford the fees needed to invest in every single stock in the sector.
The result: You would start adding stock risk to your sector risk, because you would have to pick some stocks and not others.Now consider the same situation today. If you figure the oil sector looks cheap, you can just go out and buy a sector index fund -- such as State Street's Energy Select SPDR (XLE) -- that invests across the sector. Costs? A one-time trading fee, which can be as low as $10, and ongoing management fees as low as 0.24% of your assets. And because it trades throughout the day like a stock, you can get in or out whenever the market is open. I use this particular example because it is exactly one that arose in May of 2005, when I wrote a column for the Boston Herald. Oil futures, and oil stocks, had slumped because of some hedge-fund blowups. I recommended exchange-traded funds, or a do-it-yourself basket of oil shares.