Like mutual funds, ETFs are baskets of securities. Like stocks, ETFs trade on an exchange. Unlike regular mutual funds, ETFs can be bought and sold throughout the trading day. They can also be sold short and bought on margin. Anything you might do with a stock, you can do with an ETF.

There are a number of different ETFs on the market, including Qubes, SPDRs, sector SPDRs, MidCap SPDRs, HOLDRs, iShares, and Diamonds. At the end of 2000, all ETFs were passively managed, which means that each tracks a sector-specific, country-specific, or broad-market index. A manager isn't actively choosing which stocks to buy and sell. (Though actively managed ETFs may be on the horizon.)

Why has indexing been the strategy of choice for ETFs? ETFs rely on an arbitrage mechanism to keep the prices at which they trade roughly in line with the net asset values of their underlying portfolios. For the mechanism to work, potential arbitragers need to have full, timely knowledge of a fund's holdings. So many ETFs have chosen the indexed route because active managers rarely disclose their portfolio holdings more frequently than the Securities and Exchange Commission requires (which currently is twice a year).

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