Goldberg's Picks: The 5 Best Exchange-Traded Funds for 2011

With more than 1,000 ETFs in the marketplace, picking good ones has become almost as difficult as choosing among ordinary mutual funds. Unfortunately, most ETFs are more marketing ploys than sound investments. What to do? Buy funds with low expense ratios that invest in broad swaths of the market.

Shun tiny ETFs that invest in a single industry or a single country -- or, worse yet, exchange-traded notes, which are essentially debt instruments backed only by the company that issues them. The majority of ETFs are little more than high-priced gimmicks. For instance, I’d put many of the WisdomTree family of ETFs, which weights holdings based on dividends or earnings rather than on the more-traditional basis of market capitalization, in this category. You’re better off buying an actively managed fund that seeks dividend or earnings growth. Actively managed ETFs aren’t ready for prime time, either.

This article offers my stock ETF picks for 2011. For bonds, I think you’ll do better with the actively managed funds I wrote about recently (see Goldberg’s Picks: The Best 4 Bond Funds for 2011). I don’t think indexing -- the approach employed by the overwhelming majority of ETFs -- is a good strategy for bonds this year.

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Large, growing companies are selling at dirt-cheap prices relative to their earnings, sales and cash flow. Consider Apple, arguably today’s most innovative company. At its January 11 closing price of $342, Apple trades at 17 times the average of analysts’ earnings forecasts for the next 12 months. (Adjust Apple’s price for the $52 billion in cash on its balance sheet and the price-earnings ratio is only 14.) The long-term average P/E for Standard & Poor’s 500-stock index is 15.5.

Apple is hardly alone. The U.S. and the rest of the developed world boast numerous huge, growing companies that are generating rising sales, sport high profit margins and carry little or no debt. Anomalies like this are common in the stock market. They can persist for years -- remember the sky-high prices on tech stocks in the late 1990s. But such abnormalities always end -- and the best investors wait patiently for that to happen.

The best ETF for these companies is Vanguard Mega Cap 300 Growth (symbol MGK). With a rock-bottom annual expense ratio of 0.13%, it owns the biggest U.S. growth companies based on their market value (share price times number of shares outstanding). Its biggest holdings are Apple, Microsoft, International Business Machines, Google, Cisco Systems, Coca-Cola and Exxon Mobil. If you invest only in ETFs, put 40% of your stock money here.

Large-company growth stocks are bargains overseas, too. So invest 15% in iShares MSCI EAFE Growth Index (EFG). Its largest holdings are Nestlé, BHP-Billiton and Novo Nordisk. Annual expenses are 0.40%.

Put another 25% of your stock money into Vanguard Total Stock Market ETF (VTI), a broad index of the entire U.S. stock market. So broad, in fact, that more than one-third of the stock weighting in this ETF is a carbon copy of what’s in the Mega Cap ETF. That’s okay; these are the best stocks to own today anyway. The fund charges a microscopic 0.07% annually.

Why buy the Total Stock ETF at all? Because no one can be certain about the course of the stock market. I make mistakes, and so does everyone else. This ETF gives you exposure to large-cap value stocks, as well some midsize and small stocks.

For the same reason, invest 5%in Vanguard Europe Pacific (VEA), which gives you broad exposure to the developed world outside the U.S. Its expense ratio is 0.15%.

Put the last 15% into Vanguard Emerging Markets Stock (VWO). For 0.27% annually, you get an ETF that invests in the largest emerging-markets companies. Almost 58% of assets are in Asia outside Japan, including 18% in China and 8% in India. Another 23% is in Latin America, including 16% in Brazil.

Some analysts say that emerging markets are the next bubble. True, some of these countries are facing inflationary pressures, but so far they’re acting sensibly to subdue them. Moreover, emerging-markets stocks, on average, are trading at roughly the same P/E as the U.S. stock market. Yet emerging nations continue to grow rapidly. Because emerging markets are riskier than developed markets (a view, incidentally, that some analysts are beginning to challenge), emerging-markets stocks should be cheaper than those in the U.S. But no way can you consider emerging markets to be in bubble territory.

Steven T. Goldberg (bio) is an investment adviser in the Washington, D.C., area.