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Not long ago, exchange-traded funds were a novelty. But the number of ETFs has soared from fewer than 200 two years ago to nearly 800, and they now include funds that track Turkish stocks, wind-power companies and the price of livestock. And with such profusion comes confusion. With so many ETFs focusing on so many kinds of investments, how do you know which merit your attention? Honestly, it's not easy.
ETFs have features of both stocks and traditional mutual funds. Like regular funds, ETFs pool shareholders' cash and invest it according to terms described in a prospectus. But unlike regular funds, which are priced just once a day (at 4 p.M. eastern time), ETFs trade throughout the day on the open market and are bought and sold through a brokerage. You can buy ETFs on margin, post market orders or limit orders, and sell them short to bet on lower prices.
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ETFs also have low fees. The cheapest of all is Vanguard Total Stock Market ETF (symbol VTI), which tracks the performance of the entire U.S. stock market. Its expense ratio is only 0.07%, which means that it extracts just 70 cents a year for every $1,000 invested to pay for operating costs. Many newer ETFs track a customized index or focus on narrow sectors or narrower subsectors. Their expenses tend to be higher, although specialized ETFs are almost always cheaper than specialized mutual funds.
Beyond expenses, focus on ETFs that describe their goals and methods. For example, if an ETF employs a proprietary system to build its portfolio, it should lay out a clear explanation of how it does so. You should avoid ETFs that give too much weighting to a small number of stocks. Award extra points to large ETFs, which are likely to trade more often than small funds. The more liquidity they have, the smaller the gap between "buy" and "sell" prices. Taxes are unlikely to be an issue because ETFs don't do much trading themselves, thereby minimizing the kind of taxable distributions that often annoy holders of regular funds. Here are our choices for the right ETFs in 13 popular investment classes.
Big-company stocks
An ETF that tracks shares of the biggest domestic companies should be central to your portfolio. Most of the largest ETFs are linked to Standard & Poor's 500-stock index, the Russell 1000, or the growth or value components of a big-company index. Your choice is between a simple, ultra-cheap ETF that matches an index and one that employs a system that attempts to outdo the major benchmarks while still providing a high degree of diversification.
This sets up a competition among the first ETF -- the original SPDR (SPY), or "Spider," which tracks the S&P 500 -- PowerShares Dynamic Large Cap Portfolio (PJF) and Vanguard Large Cap ETF (VV). The Spider charges 0.09% annually. Vanguard Large Cap follows an MSCI index of 750 "prime" U.S. stocks (essentially the S&P 500 plus major midsize companies) and costs only 0.07% a year. PowerShares, which charges 0.65% annually, uses a system called Intellidex to winnow the most earnings-challenged companies from the major indexes, yielding a portfolio of 100 stocks. That's enough to provide decent diversification and a 1.9% yield, nearly as much as the other two ETFs. Since its launch in December 2006, the PowerShares fund's performance has more than offset its higher expenses. Unless you are a die-hard traditionalist, it's the pick.
Small-company stocks
PowerShares has a similar fund for low-capitalization stocks, but given the greater volatility in small-company shares, we prefer more diversification in this category. So our choice is Vanguard Extended Market index ETF (VXF), which reflects the perform-ance of more than 3,000 small- and midsize-company stocks. It charges just 0.08% a year and won't deliver any surprises. It's ideal for a core position in small companies, but it won't soar as high as the best mutual funds when the category rallies. If you want to take extra risk to angle for higher returns, pair the ETF with a traditional mutual fund, such as Baron Small Cap (BSCFX) or Royce 100 (RYOHX).
International stocks
WisdomTree, an ETF sponsor for which Kiplinger's columnist Jeremy Siegel serves as a strategist, creates indexes that overweight either high-dividend payers or stocks with low price-earnings ratios. WisdomTree DEFA (DWM) includes more than 500 stocks from Europe, the Far East and Australia that meet its dividend screens but otherwise differ only a little from the better-known MSCI EAFE index.
The WisdomTree method also ensures that no stock in any of its ETFs will have an outsized effect on perform-ance; only six stocks in DEFA -- the acronym stands for Dividend Index of Europe, Far East Asia and Australasia -- account for more than 1.5% of the portfolio. The fund yielded 1.5% at last report and provides plenty of diversification as well as a buffer against the risks of owning highly valued stocks. Annual expenses of 0.48% are fair.
POSTED BY: the dude (August 22, 2008 02:39 PM)
You get what you pay for. Spending 70 cents for a $1000 investment? What makes that better? Is McDonalds better than Ruth's Chris because it is cheaper?
POSTED BY: melissa (August 26, 2008 11:49 AM)
"Is McDonalds better than Ruth's Chris because it is cheaper?" Yes, if you're getting the exact same meal at both places. There are etfs that mirror almost every stock index fund. If you're a long term investor and investing within a tax-deferred accounts, an etf can do the same job as an index mutual fund.
POSTED BY: kannankeril (September 21, 2008 12:53 PM)
"You get what you pay for." Not according to one Mr. Warren Buffet. Try a Google search on
'warren buffet hedge fund bet'
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