Wretched Excess Hits ETFs

More and more exchange-traded funds are being brought public, but few are worthy of your money. Many invest in narrow industry segments, and some charge high expense ratios. Still, many ETFs are compelling. Here's how to find the remaining good ones.

By Steven Goldberg

published 3 August 2006

in Features

Wall Street has proven repeatedly that nothing succeeds like excess. Take a good idea, replicate it 1,000 times and you have created probably ten good products, 990 bad products and made it nearly impossible for ordinary investors to separate the good from the bad. But Wall Street could care less because this proliferation of products means more money for investment companies.

Take mutual funds. Counting multiple share classes, there are something like 20,000 funds nowadays.

Now Wall Street is bringing that same "magic touch" to exchange-traded funds (ETFs).

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Consider PowerShares Dynamic Biotechnology and Genome (PBE). Like many PowerShares ETFs, this one uses "intelligent indexes" to select stocks in that narrow sector using a quantitative system. The idea is to assemble a package of biotech stocks that beat the biotech indices. The ETF's annual expense ratio is capped at 0.60%.

In my humble opinion, investors should welcome this product as much they would welcome margin calls. It's at once too narrow, too confusing, unproven and too costly.

Lest you think this ETF is an aberration, there are roughly 275 ETFs on the market today -- including more than a dozen that focus on health and biotech stocks alone. A few of the odder ones: PowerShares Autonomic Allocation Research Affiliates, First Trust DB Strategic Value Index and PowerShares India Tiger.

The best choices

ETFs were a great idea. They still are. The initial concept was to offer easy-to-trade index funds that charged even less than the traditional index mutual funds sold by companies like Vanguard and Fidelity. The original ETFs, which track broad barometers, such as Standard Poor's 500-stock index, the Nasdaq Composite Index and the Dow Jones industrial average, make great long-term investments. And it's no sin to take a flyer on a narrow sector ETF with a wee bit of your money.

But you want ETFs to charge low fees, to have enough liquidity so that your trades get executed well and to be simple to understand.

How to reach what now appears a towering goal? I'd stick mainly to the big companies that pioneered ETFs: iShares, State Street Global Advisors, and Vanguard. Missing from this list are the SPDR products -- the originals. Their products don't strike me as quite as well constructed as those of the other firms.

As far as fund selection, the broad market indices are great for index investors. Vanguard Total Stock Market (VTI) gives you the whole stock market in one wrapper for just 0.07% annually. The iShares SP 500 (IVV) gives you the large-cap-dominated SP 500 index for just 0.09% annually.

When trading the more obscure ETFs, be sure to use limit orders. Otherwise, you could end up paying far more for your shares than you expected.

Steve has been writing for Kiplinger's for more than 25 years. As an associate editor and then senior associate editor, he covered mutual funds for Kiplinger's Personal Finance magazine from 1994-2006. He also authored a book, But Which Mutual Funds? In 2006 he joined with Jerry Tweddell, one of his best sources on investing, to form Tweddell Goldberg Investment Management to manage money for individual investors. Steve continues to write a regular column for Kiplinger.com and enjoys hearing investing questions from readers. You can contact Steve at 301.650.6567 or sgoldberg@kiplinger.com.