Getting Past the ETF Clutter

published 1 September 2008

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.

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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.

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.

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).

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.

Play this category with SPDR S&P Emerging Markets (GMM). It mainly holds huge, world-class multinationals, such as India's Reliance Industries and Israel's Teva Pharmaceuticals, that happen to call an emerging nation home. One-fourth of the ETF is in energy stocks, so if you have large investments in oil and gas, you may find some overlap. Then again, Russia's Gazprom and Brazil's Petrobras are long-term keepers in any global portfolio, and this ETF is a cheap way to hold them.

WisdomTree's style, which includes projecting future payouts, gives it a leg up in the domestic dividend derby. WisdomTree Total Dividend (DTD) holds about 850 dividend payers, including some, such as banking giant Wachovia, that have slashed their disbursements lately. Because Total Dividend carries an above-average weighting in financial stocks, it performed poorly in 2008, losing 16% in the year's first six months. But once banks, real estate and consumer spending revive, Total Dividend should benefit from WisdomTree's efforts to project which companies will raise dividends fastest.

In this category, we prefer an ETF that distributes assets widely and avoids weighting holdings by market capitalization. A good choice is Rydex S&P Equal Weight Technology (RYT), which, as its name suggests, treats all of its holdings equally. No stock is more than 2% of the fund's assets. By contrast, Microsoft, whose shares sank 22% in the first six months of 2008, represents 12% of iShares Dow Jones US Technology (IYW). Microsoft could rally and make our pick look dumb. But if you want a wide-ranging shot at riches in tech, one for which a breakthrough by a midsize software or Internet company counts as much as good news from Hewlett-Packard or IBM, the Rydex fund is your ticket.

Most health ETFs are either narrowly focused (what is "emerging cancer," anyway?) or top-heavy with the likes of Johnson & Johnson, Pfizer and the big European drug makers. Ideally, a health-sector ETF would own Big Pharma stocks for their juicy dividends but also smaller, fast-growing biotechnology and medical-device companies. But you can't get that combo in one ETF. The best compromise is to buy Rydex S&P Equal Weight Healthcare (RYH) for the domestic share of your health-stock allocation and a traditional global health fund as a complement. It's a shame no ETF offers a portfolio similar to those of Janus Global Life Sciences (JAGLX) and Eaton Vance Worldwide Health Sciences (ETHSX), two regular funds.

Most ETFs fail to pass muster. An exception is SPDR dj Wilshire Global Real Estate (RWO). The ETF is well diversified, with 217 stocks and slightly more than half of its assets overseas (the fund's four biggest holdings are companies based in Australia, the U.S., Japan and Canada; the fifth-largest is a Dutch-French venture). Expenses are reasonable, at 0.50% annually. Forget this ETF's short-term results (down 12% from its launch on May 7 to July 1), which are due to the wretched state of the global stock and real estate markets.

Utilities aren't the income stocks they once were. So, in picking a utility ETF, look for one that invests in companies that pay some dividends but also offer growth potential. Companies most likely to fit that bill are those that can help meet the developing world's hunger for reliable water and power or can repair this country's aging infrastructure. SPDR FTSE/Macquarie Global Infrastructure 100 (GII) is a creative ETF that includes major U.S. gas and electric utilities, such as Exelon and FPL, and European and Asian utilities. SPDR FTSE/Macquarie is one of the few funds, outside of energy and com-modities, that can boast a positive (4%) return over the past 12 months.

Banks, brokers, mortgage companies and other financial stocks have been battered, so you'll need nerves of steel and deeply held contrarian views to dive into a financial-sector fund. When the recovery finally comes, a major beneficiary will be ProShares Ultra Financials (UYG). The fund uses futures and options to deliver twice the daily return of the Dow Jones U.S. Financial Index. As AIG, Bank of America and Citigroup have tanked, the ETF has fallen off a cliff (it lost 49% in the first half of 2008). Ultra Financials has speculative appeal, but wait for signs that the financial economy is on the mend before investing.

If you merely want to track the price of gold, either iShares COMEX Gold Trust (IAU) or SPDR Gold Shares (GLD) will work just fine. Both ETFs hold only bullion -- no mining shares, futures or options. Neither employs leverage. Annual fees, at 0.4%, are identical. Yet, in 2006, 2007 and the first six months of 2008, SPDR Gold outpaced its iShares rival by a smidge. There's no way to predict whether this will continue. So, as bettors like to say (and there needs to be a bit of a bettor in you to invest in bullion): Pick 'em.

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Kosnett is the editor of Kiplinger's Investing for Income and writes the "Cash in Hand" column for Kiplinger's Personal Finance. He is an income-investing expert who covers bonds, real estate investment trusts, oil and gas income deals, dividend stocks and anything else that pays interest and dividends. He joined Kiplinger in 1981 after six years in newspapers, including the Baltimore Sun. He is a 1976 journalism graduate from the Medill School at Northwestern University and completed an executive program at the Carnegie-Mellon University business school in 1978.