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The 7 Best ETFs for This Market

Broad-based indexing doesn’t make sense in a market with so many bargains -- and so much dangerously overpriced merchandise.

Buying a few exchange-traded funds that blanket the entire market is usually a superb strategy. Not now. The key in this market is to cherry-pick the juiciest parts -- and be wary of the rest.

With its wide gap between cheap and pricey, the stock market today somewhat resembles the one of the late 1990s. Back then, technology and telecommunications stocks sported insanely high valuations, while shares of small companies in general and providers of mundane products and services of any size were dirt-cheap.

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Today’s market is, to a degree, a mirror image of stocks a decade ago. Many so-called value stocks, small-company stocks and real estate investment trusts trade at inflated valuations. Most bonds are also pricey. Meanwhile, shares of large, growing U.S. companies -- the world’s superstars -- are wonderful values. So are stocks in emerging markets.

Exchange-traded funds, which typically seek to track an index, offer the lowest-cost way to access the markets (both stock and bond). Here, I offer my seven top ETF picks for the rest of 2010, as well as the percentage of your assets I recommend investing in each of them if you want to build an ETF-only portfolio to capitalize on this market. This is an aggressive mix. Given continued uncertainty about the health of the global economy, I don’t think most investors should have more than 80% of their investments in stocks. If you’re older or more conservative, consider upping your percentage in bonds.

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Begin building your ETF portfolio by investing in the biggest and strongest companies -- stocks of mega-cap growth companies. Put 35% of your money in Vanguard Mega Cap Growth 300 ETF (symbol MGK). The average market value (share price times number of shares outstanding) of its stocks is $54 billion. More than one-third of the stocks are in tech and telecom. The stocks’ average weighted return on equity (a measure of profitability) is an impressive 25%. Analysts expect the companies in this fund to produce earnings growth of 12% annually, on average, over the next three to five years.

The surprise: The price-earnings ratio of these stocks, based on earnings estimates for the next 12 months, is a mere 17. That’s hardly dirt-cheap, but it’s a much lower P/E than the best U.S. companies normally fetch. The ETF’s annual expense ratio is just 0.13%, and its current yield is 1.3%.

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The great thing about this ETF is that it’s likely to do well if the market rallies but to fall much less than the market in a selloff. Its holdings are as close as any stock can be to bulletproof. The ETF’s biggest holdings: Microsoft (MSFT), Apple (AAPL), International Business Machines (IBM), Cisco Systems (CSCO), Google (GOOG), Wal-Mart Stores (WMT), Hewlett-Packard (HPQ) and PepsiCo (PEP).

Put an additional 15% of your investments in Vanguard Emerging Markets Stock ETF (VWO). Emerging nations continue to grow much faster than the rest of the world. Yet the shares of most emerging-markets companies are cheap relative to anticipated earnings. For 0.27% annually, this ETF gives you exposure to companies in emerging markets around the world. Its biggest holdings are in China, Brazil, South Korea, Taiwan and India.

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Large-company growth stocks and emerging-markets stocks are the sectors that, in my view, offer the most potential for profits. But no matter how confident you are in your outlook, you should still hedge your bets -- the stock market has a way of making even the seemingly smartest analysis look silly.

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So put 10% into Vanguard Europe Pacific ETF (VEA). It tracks stocks in developed foreign markets. Invest another 15% in Vanguard Extended Market Index (VXF), which tracks stocks of small and midsize U.S. companies. Finally, invest 5% in Vanguard Mega Cap 300 Value Index (MGV), which invests in undervalued behemoths.

Keep it simple with your bond money. If your federal income-tax bracket is 25% or higher (taxable income of at least $68,000 for a married couple and $34,000 for a single person), put the remaining 20% of your money in iShares S&P National AMT-Free Municipal Bond ETF (MUB). This is the largest and easiest-to-trade muni ETF. Expenses are just 0.25%. Its 30-day yield is 3.0%.

If you’re in a lower tax bracket, choose iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD). It invests in high-quality corporate bonds, charges just 0.15% annually and yields 4.3%. Avoid Treasury bonds. Because of flight-to-quality buying, their prices have been bid up, resulting in a big drop in yields to unappealing levels.

This is not a buy-and-forget portfolio. My sense is it will serve you well for the next year or so, but eventually the biggest and best companies, as well as emerging markets, will be bid up in price. That will be the time to change your investments.

Steven T. Goldberg (bio) is an investment adviser.

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