ETF Spells Opportunity

With a wide variety of exchange-traded funds now available, it’s easy to assemble an all-ETF portfolio that meets your investing needs.

By Steven Goldberg, Contributing Columnist

From Kiplinger's Personal Finance magazine, July 2005

For Amy and Eric Schorn, investing is simple. The Dallas couple own only a few stock funds, but each fund invests in different kinds of companies: large companies, small ones, foreign concerns and so on. What's more, their funds require virtually no monitoring, boast breathtakingly low expense ratios and are almost certain to outpace the vast majority of competing funds.

The Schorns' secret? They invest in exchange-traded funds, the fastest-growing segment of the fund industry. From none a dozen years ago, there are now more than 175 ETFs holding about $228 billion in assets. Not bad for products that are essentially index funds that mimic market barometers.

But ETFs are index funds with a twist. Unlike traditional index funds, which you can buy or sell only once a day, ETFs trade throughout the day. You buy and sell them through a broker, just like ordinary stocks. ETFs also come in more varieties than conventional index funds. (For a guide to some intriguing ETFs, see A Fund for Every Taste.)

Both ETFs and regular index funds boast rock-bottom expenses. "But ETFs tend to cost even less than traditional index funds," says John Gay, the financial planner who helped the Schorns, both dentists, choose their ETFs. Because of their low expenses, index funds tend to outpace similar actively managed funds over long periods of time.

The biggest drawback of ETFs is the pesky brokerage commission you pay each time you buy or sell one. So investors engaged in dollar-cost averaging are usually better off using regular index funds rather than ETFs. But if you plan to buy and sell in large chunks and you trade through a discount broker, a commission of $10 or so may be inconsequential.

Although ETFs are attractive on their own merits, it's still important to incorporate them into an overall investment plan. Consider these five ways to take advantage of the range of ETFs.

Sweet and simple

You could, like the Schorns, assemble an all-stock portfolio with ETFs. If you won't need your money for at least ten years and you have a high tolerance for risk, you could put 75% to 80% of your money in Vanguard Total Stock Market Vipers (symbol VTI) and the rest in iShares MSCI EAFE (EFA). The former, which tracks the entire U.S. market, sports an expense ratio of just 0.07%Ñwhich means that the fund extracts only 70 cents per year for every $1,000 invested. The latter follows a broad index of foreign stocks in developed countries. Its expense ratio is 0.35%.

Balanced approach

Does the volatility of an all-stock portfolio frighten you? No sweat. Dampen your portfolio's risk profile by adding a couple of bond ETFs. You could put 65% of your money in the previously mentioned stock-oriented ETFs and split the rest between two bond funds: iShares Lehman Aggregate Bond (AGG), which mirrors the investment-grade portion of the U.S. bond market, and iShares Lehman TIPs Bond (TIP), which invests in an index of Treasury inflation-protected securities, bonds that provide some insulation against rising prices. Each bond ETF carries an expense ratio of only 0.2%. (No ETFs specialize in municipal bonds, so if you want tax-free income, you'll have to invest in a conventional tax-exempt fund.)

ETFs for income

If you're a young retiree or are getting ready to call it a career, you'll want to place even more emphasis on dividends and yield. Place 40% of your money in bond ETFs and 10% in iShares Cohen & Steers Realty Majors (ICF), which owns high-yielding real estate investment trusts and charges just 0.35% annually for expenses. Divide the rest of your assets among Vanguard Total Stock Market Vipers, iShares MSCI EAFE and iShares Dow Jones Select Dividend (DVY), an ETF that focuses on high-yielding stocks (see A Fund for Every Taste").

For side bets

ETFs let you make investing as simple or as complex as you'd like. Suppose you want to make some bets based on "The Secret Strength of Stocks" (in the July issue of Kiplinger's Personal Finance). You can lift your exposure to fast-growing large companies, an area of the market that we consider attractive, by trimming your holdings in Vanguard Total Stock Market Vipers by 15 percentage points and moving the money into iShares S&P 500/Barra Growth (IVW; expense ratio, 0.18%). This fund invests in the half of Standard & Poor's 500-stock index that contains the presumably faster-growing companies with higher price-to-book-value ratios (book value is assets minus liabilities). You can also juice up your portfolio by reducing your allocation to the MSCI EAFE fund and shifting the money to Vanguard Emerging Markets Stock Vipers (VWO; expense ratio, 0.30%), which invests in companies based in fast-growing, but volatile, developing nations.

Hedging strategies

Employees can use ETFs to lessen their financial dependence on their employers and industries. Say you work for ExxonMobil and own a tankful of the energy giant's stock or options. Between your job and your stock, you may have more invested in energy than is prudent. So, you can sell short shares of Vanguard Energy Vipers (VDE; expense ratio, 0.25%).

If Exxon and energy stocks in general sink, your short position should offset some of your Exxon losses. Alternatively, you could invest in ten of Vanguard's 11 broad sector Vipers, omitting only the energy ETF. That would give you a more diversified portfolio.

A cautionary note: Trading in some ETFs is sparse. To be safe, always use a limit order -- an order to buy or sell at a predetermined price. Find out what the bid and asked prices are for an ETF. If the spread between the two is more than a nickel or so per share, place your order in between the two prices. Web sites that provide useful information about ETFs include Amex.com, iShares.com and Morningstar.com.

Research: Elizabeth Kountze

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