Exchange-traded funds a flexible option

Your Money

February 25, 2007|By Carolyn Bigda

Buy a broad mix of stocks and bonds. Keep expenses low. Don't bother trying to beat the market's average return.

That's been the mantra of index mutual funds since John Bogle, founder of the Vanguard Group Inc., introduced the first one in 1976.

For many investors, the strategy has paid off.

Now, the next generation of index investing - exchange-traded funds, known as ETFs - is coming of age and attracting a lot of attention. Like index mutual funds, ETFs buy a basket of stocks or bonds that mimic a particular market benchmark, such as the Standard & Poor's 500.

But, in a twist on Bogle's creation, ETFs can be traded on the market throughout the day like an individual stock. In contrast, a mutual fund's share value is adjusted only at the end of the day.

Some other features also may appeal to investors.

ETFs tend to be more tax efficient and charge lower fees than mutual funds.

The average expense ratio for an ETF that invests in U.S. stocks is 0.39 percent, according to Chicago-based Morningstar Inc. For an index mutual fund in the same category, the average is 0.72 percent.

Actively managed funds, in which a fund manager tries to outperform the market by selecting stocks, are even more expensive - 1.47 percent on average.

ETFs give the everyday investor a chance to invest in specific industries, such as energy and gold, for less than through mutual funds.

You can own not only the stocks of companies within the sector, but such items as oil and gold bars, too - a set of assets that don't always move in the same direction as stocks, helping diversify your portfolio.

However, there are some drawbacks, especially for investors who are just starting. So, you may not want to drop your mutual funds just yet.

The bigger investment the better.

Though ETFs charge low expenses, you have to pay a brokerage commission each time you want to invest in one.

Using an online brokerage can minimize the cost to a handful of dollars, but if you're investing only $50 at a time, the fee can become a sizable portion of the investment.

"ETFs are not going to make sense for someone who is investing in dribs and drabs," said Russell Wild, author of Exchange-Traded Funds for Dummies. "They're better for lump-sum investments."

ETFs are not readily available in 401(k)s.

Most employer retirement plans don't offer ETFs, mainly because of the brokerage fees that workers would owe with every paycheck and the record-keeping it would require of employers.

Although some companies are working up solutions to these issues - spreading fees out among a wide pool of investors, for instance - for now, you generally won't find ETFs in your 401(k).

You could get cocky.

Finally, ETFs can make it tempting for investors to chase hot sectors. And some indexes that ETFs track are narrowly defined, such as health-care companies researching cancer treatments.

"That's almost as dangerous as investing in a single stock," Wild said.

And it won't help you build a well-diversified, long-term portfolio, especially if you're tempted to trade ETF shares regularly.

"It's very difficult to call short-term market moves and a quick way to get burned," said Sonya Morris, editor of Morningstar's ETFInvestor newsletter.

Morris recommends that young investors stick with solid building blocks in their portfolio and points out that fees for broad-based ETFs and index mutual funds can be close: 0.07 percent for the cheapest ETF compared with 0.10 percent for an index mutual fund.

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