In recent years, more and more investors are selecting Exchange Traded Funds (ETFs) over mutual funds. But what exactly is an ETF, and how do they differ from the traditional mutual fund? Modern Portfolio Theory (invented by Nobel laureate Harry Markowitz) states that in order to minimize risk, investors should hold a portfolio of many uncorrelated (unrelated) stocks, similar to the expression “don’t put all of your eggs in one basket.” The problem with MPT is that the average investor would need a lot of money and time to create such a diversified portfolio. Mutual funds and ETFs solve this limitation by allowing investors to gain immediate diversification by combining their funds together.

If you are thinking of investing some of the idle cash in your non-retirement accounts before year-end, avoid mutual funds because you will owe taxes. As mutual funds buy and sell securities in the fund during the year, they incur capital gains and losses. Mutual funds are required by law to distribute virtually all capital gains made throughout the year to their shareholders in the form of capital gain distributions. These funds usually pay out yearly capital gains distributions to their shareholders of record in December. The date of record is how the mutual fund determines who is eligible for the distribution. Therefore, if you purchase shares before the date of record, you will be entitled to the distribution and have to pay the subsequent taxes even if you didn't benefit from that fund's growth during the year. While it may sound like a good idea to buy a fund and get immediate income, beware that the fund value (known as Net Asset Value) declines on the date of payment by the exact amount of the distribution. So while you receive a taxable distribution, your asset value also declines by an equal amount. Most investors prefer Exchange Traded Funds (ETFs) over mutual funds (click for an article on the differences between mutual funds and ETFs) because of their tax efficiency (most ETFs do not pay capital gains distributions). But caution should still prevail; some ETFs  may still distribute capital gains. To avoid having to pay tax on an investment you purchase in December, look on the fund's website to find out their date of record and make your purchase after that date.