With Exchange Traded Funds (EFTs) you can easily invest in indexes and sectors -- without the disadvantages of using mutual funds.

An Exchange Traded Fund is a large inventory of stocks or other investments matching one particular index (such as the S&P 500) or sector (such as gold or Japan). This provides you with one of the most important ingredients for long term investing success -- diversification.

Diversification is also one of the great advantages of mutual funds. So why not just stick with mutual funds? Because EFTs provide a flexibility and convenience you can't get with mutual funds. Plus, they eliminate one of the worst problems of mutual funds -- having to pay capital gains tax even when you lost money. Plus, they have lower expenses than mutual funds.

The EFT company buys up a large amount of the fund's particular kind of investment. This is usually some type of index such as the S&P 500 or the Dow Jones Industrial Average. It can also be an index of a particular sector, such as the top energy stocks or the top companies of Brazil.

The company issuing the EFT then sells shares in the overall fund. These shares are then bought and sold in the secondary market. That is, they're available for sale for you to buy using your broker -- just like shares of stock. The investment inventory held by the EFT remains constant.

Mutual funds buy and sell shares of their investments every time a new account is opened, a deposit is made or money is withdrawn. Therefore, mutual funds are constantly trading their underlying investments.

This does not take place with EFTs. You buy your shares from a broker. The underlying investments remain in place with the EFT company.

Because mutual funds are constantly buying and selling their underlying investments, they're constantly realizing taxable losses and gains, which is passed on to you -- which affects your end-of-the-year tax liability. It's entirely possible that by the end of the year a mutual fund has incurred taxable capital gains that you must pay taxes on -- but its price by December 31 is lower than it was on January 1! But the IRS still wants you to pay the taxes.

With Exchange Traded Funds, you have capital gains or losses only when you sell your own shares in the EFT. The EFT issuing company does not buy and sell the underlying investments unless it's tracking an index and the index itself changes.

Another advantage of EFTs is that you have the flexibility to buy and sell your shares. Let's say you decide that gold is going to go up in price and therefore you want to transfer some of your money from the S&P 500 index to gold.

If you have your money in a typical mutual fund family they will not allow you to switch funds often. And if you don't already have an account in their gold mutual fund, you'll have to read the prospectus before they can allow you to open one.

With EFTs, you just order your broker to sell some of your "Spiders" (the nickname for the S&P 500 index EFT) and buy shares of a gold EFT. Or an EFT investing in Europe. Or Internet stocks.

EFTs also have lower costs than mutual funds. That's because they aren't continually buying and selling investments, tracking who owns what shares and so on. Once they've set the exchange traded fund up, there's a lot less administrative paperwork on an ongoing basis. Even Vanguard's notoriously low in expenses S&P 500 index fund has higher administrative expenses than EFTs.

Both mutual funds and EFTs offer you the benefits of diversification and investing in broad and sector indexes. However, EFTs have lower expenses, more flexibility and fewer capital gains taxes.