The Only Three ETFs You Need

Exchange-traded funds -- mutual funds that you buy and sell like stocks -- started as a way to make investing simpler and cheaper. They still can be. If you're someone who doesn't enjoy analyzing securities in your spare time, ETFs offer a terrific way to put your investments on autopilot. This article will tell you how to use them to make investing a snap.

But first the bad news. Sorting through ETFs has become almost as daunting as choosing among mutual funds or individual stocks and bonds. Sixteen different companies now offer more than 500 ETFs combined. In April alone, 21 new ETFs were launched, according to State Street Global Advisors.

The proliferation of ETFs is all about how those 16 companies try to make a buck. It has little to do with helping you become a better investor. Look at some of the underwhelming offerings. Seventeen different ETFs now invest in commodities, 11 in currencies, 22 in technology stocks and 33 in health care stocks. Looking for a way to invest in real estate investment trusts? Barclays Global Investors this month rolled out five ETFs, each investing in a different REIT subsector. I simply can't imagine why any individual investor would need such a narrowly focused ETF.

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As time goes on, the offerings are getting wackier. The Web site www.indexuniverse.com reports that "XShares continued the steady rollout of its (planned) 21 HealthShares ETFs with the April 19 launch of the HealthShares Dermatology and Wound Care ETF." I have a great appreciation for health care, and I've even visited a dermatologist a few times, as well as patched up more than a few cuts and scrapes with bandages. But why on earth would I want to buy a fund with such a narrow mandate? What's more, this ETF charges 0.75% annually, more than some regular mutual funds charge.

In the process of creating all these less-than-useful ETFs, something else got lost: ETFs' original focus on keeping costs low. The best ETFs still charge miniscule expenses, but others charge 0.6% a year, 0.75% and more. Given that you have to pay a brokerage commission to buy and sell an ETF, ETFs with such high prices make no sense.

Originally, ETFs had to be index funds, which was a terrific idea. In general, index funds track a broad market average, which makes them ideal for people who don't want to spend a lot of time on their investments. But now ETF sponsors want to launch actively managed ETFs. These will compete with ordinary mutual funds, most of which are actively managed. PowerShares already runs quasi-active funds by having ETFs linked to indexes that change periodically.

All this, of course, is how free markets work. Someone has a great idea. Others emulate it. The industry mushrooms, and eventually there's a shakeout. Some ETFs are already starting to disappear for lack of investor interest. But until a real shakeout takes place, the plethora of products serves mainly to confuse investors.

So what's an ordinary investor to do?

Let's dismiss one argument right away: Let the professionals argue over whether ETFs are superior or inferior to regular index funds. The differences in costs are so tiny that for most investors the answer is to pick whichever you feel more comfortable with. True, the best ETFs charge a little less than the best index funds. And, yes, if you're investing small amounts regularly, the brokerage costs of ETFs will eat you alive, unless you do business with a brokerage firm that offers no-commission trading. (See No-Commission ETFs.) But for most investors, the difference between an ETF that charges 0.09% and an index fund that charges 0.20% is hardly worth worrying about.

If you currently invest in traditional mutual funds, you'll probably do best with index funds. (See Really Simple Investing.) The best of these are offered by Fidelity or Vanguard. If you use a brokerage, you'll likely do better with ETFs offered by Vanguard. Why? Because Vanguard's fees are the lowest.

A three-ETF portfolio

What's great about broad-based ETFs is that they do track indexes. That makes them the perfect investment for people who want to buy their funds and forget about them. Since these ETFs follow an index, there's no need for you to monitor them. It doesn't much matter if the manager changes. The index will remain largely the same.

Which ETFs to buy? Start with Vanguard Total Stock Market ETF (VTI), which charges just 0.07% annually in expenses. The fund tracks the MSCI Broad Market Index -- which means it essentially gives you the entire U.S. stock market. Put three-quarters of your stock money in this ETF.

For the final quarter of your stock money, Vanguard again has the best ETF: Vanguard FTSE All-World ex-US ETF (VEU). For 0.25% annually, this ETF gives you the entire world except the U.S.

It's a similar story with bonds. Vanguard Total Bond Market ETF (BND) is the low-cost option, with annual expenses of 0.11%. If you're investing in a taxable account, however, substitute Vanguard Intermediate-Term Tax Exempt (VWITX), a regular mutual fund that invests in high-quality, tax-free bonds.

All that's left is to decide what proportion of your money you want in stock ETFs, and how much in bond ETFs. Keep 90% or more of your money in the two stock ETFs until you're about six years from retirement. Then, gradually sell some stock ETFs until you have about 40% in bonds during retirement. For your children's college savings, put 90% or more in the stock ETFs until your child is about ten years from college. Then, gradually sell your stock ETFs and then your bond ETFs until you're entirely in cash by the time your child's junior year of college begins.

The only other thing you need: discipline. Keep investing regularly, regardless of what the market does. Of course, that's a lot easier said than done. All I can say on that score is "do it."

Steven T. Goldberg is an investment adviser and freelance writer.