Think your mutual fund manager is doing a good job? You might want to check that performance record again. Over the long-term, few managers can outdo the overall market. In fact, only 4% of stock funds beat Standard & Poor's 500-stock index over the past decade. You can match market performance with a mutual fund that tracks a particular index, but an easier and more cost-effective approach is through exchange-traded funds.

Like more traditional mutual funds, an ETF is composed of a portfolio of stocks. The portfolio generally represents a slice of the market -- an index, a defined group of stocks within an index or an industry sector. But unlike most mutual funds, ETFs trade like stocks. There are no loads or other charges, and management fees are much lower than on comparable index mutual funds. For example, Vanguard Total Stock Market Vipers (VTI) tracks the Wilshire 5000, and charges 0.15%. That's less than its mirror-image fund, Vanguard Total Stock Market (VTSMX), charges investors.

The popularity of ETFs has increased dramatically over the past few years. There are more than 175 ETFs with more than $200 billion in assets. And investment companies are steadily feeding investors' appetite for more.

A plethora of options

Some ETFs represent broad measures of the market, some represent small slices: So-called Diamonds (DIA) track the 30-stock Dow Jones industrial average; Spiders (SPY) and iShares S&P 500 (IVV) follow the S&P 500 index. The Russell 1000 Growth (IWF) tracks large, faster-growing companies, and the Russell 2000 Value (IWN) follows small, bargain-priced stocks. Some own the biggest companies in a given industry, such as health or real estate. One of the most popular ETFs is known as Cubes (QQQQ) and it tracks the Nasdaq 100 -- an index of the 100 largest nonfinancial companies on the Nasdaq market. The index is a good proxy for big technology stocks, such as Microsoft, Cisco Systems, Intel and Dell.

There are ETFs that invest in single countries and diversified international ETFs. Most trade on the American Stock Exchange, and the Amex Web site is valuable resource on the subject, as is iShares.com from Barclays Global Investors, sponsor of the iShares family of ETFs.

There are even bond ETFs, so it is possible to build a complete diversified portfolio from ETFs. We break down a growth-oriented and an income-oriented portfolio below.

Advantages of ETFs

Rock-Bottom Fees. The main draw of ETFs are their low fees. And because ETFs track set indexes, you'll get the same results with the cheapest one as you would a more expensive offering. The expense ratio of QQQQ is 0.2% a year, or $2 per $1,000 invested. The cheapest regular no-load mutual fund that tracks the Nasdaq, Fidelity Nasdaq Composite Index (FNCMX), has an annual expense ratio of 0.45%. The cheapest no-load technology fund, E*Trade Technology Index (ETTIX) has an expense ratio of about 0.68% per year, and the average tech fund charges 2.06%.

Some of the ETFs that focus on broader indexes are even cheaper -- as low as 0.09% a year for iShares S&P 500 (IVV). ETFs' low expenses are due in part to the economics of indexing, which minimizes the need for managers and analysts.

However, you will need to open a brokerage account and pay a commission each time you trade an ETF. That could make dollar-cost averaging expensive. While investing regularly is still a good idea, you might want to assess your frequency.

Lower Taxes. Indexes don't shift their holdings very often, so there is rarely any reason for ETFs to distribute anything except dividend income, which is minimal.

Immediacy. Because ETFs trade like stocks, your trade is executed at the price when you place it. With mutual funds, your trade is executed (with a few exceptions) at the price as of 4 p.m. eastern time that day.

Transparency. Mutual funds are required to report their holdings only once every six months. That means you can never be sure what your fund holds at any given moment. That doesn't matter when a fund tracks the S&P 500, but it does with sector funds.

Sophisticated Trading Opportunities. If you want to bet against the market in which an ETF concentrates, you can sell it short. If you want to leverage your investment, you can borrow from your broker and buy an ETF on margin. What's more, you can impose stop-loss and limit orders that trigger, say, an automatic sale if an ETF you own falls to a certain price that you specify in advance.

Making the switch

If you decide it's time to fire your fund manager and plan to shift into indexes, you'll need a strategy. You can move investments inside an IRA without tax consequences. With taxable accounts, you'll need to develop a selling plan and move slowly into index funds to soften the tax bite. Richard Ferri, a financial planner in Troy, Mich., and author of All About Index Funds (McGraw-Hill, $17), suggests this approach: Gradually invest half your portfolio in indexed investments and retain the individual stocks that, if sold, would generate the biggest capital gains (assuming the stocks are ones you're comfortable owning anyway).

Sample portfolios

Whether you invest in ETFs, individual stocks or mutual funds, three basic strategies apply:

• Keep your stock allocation above 50% to combat inflation over the long-term. Although stocks carry more risk, they average higher historical returns than other investments.



• Spread your risk with a diversified portfolio to cushion sharp declines or cyclical downturns.



• Rebalance your portfolio annually or when allocations get out of whack to keep your allocations in line. (For more information, see Devise a Rebalancing Plan.)

Growth Portfolio | For an investor with a time horizon of at least five to ten years.

Income Portfolio | For a more risk-averse investor, or one seeking more income.

MORE: Kiplinger.com | Investing | Mutual Funds

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