Investors who are leery of mutual funds, because of high expenses or reports of improper
practices, may prefer to invest in exchange-traded funds (ETFs). As the name suggests, ETFs
are bought and sold on an exchange, like stocks, but they hold a diversified mix of stocks
or bonds.
Five years ago, there were only 33 ETFs. Now, the number of ETFs has grown ten-fold, to
more than 330. ETFs have filled in all the asset allocation boxes so you can develop a
complete portfolio by holding only ETFs.
In practice, ETFs are used most frequently for blue chip stocks. The domestic large-cap
market is the most efficient, meaning that it’s difficult for mutual fund managers to add
value. Investors often prefer low-cost index funds, known as “passive” investment vehicles,
and ETFs include some of the least expensive index funds.
ETFs also provide a handy way to invest in emerging markets, if you want to participate in
fast-growing economies such as China and India. These markets are expensive for investors
because of trading spreads and transaction fees. To cut your costs, you may prefer a
passive approach by using an index-tracking ETF.
There are several ETFs that track blue chip stocks, emerging markets, and other asset
classes, so how can you decide which ones to use?
- Look at the underlying indexes. The Russell 1000 Value index, for example, is a pure
large-company index, chosen by quantitative measures. The S&P 500/Barra Value index, on the
other hand, has profit and liquidity requirements for the stocks in the index. You need to
decide which one is best suited for your asset allocation, pure style or high quality.
- Costs may make a difference. Some ETFs have lower expense ratios than others. You also
must watch the spread between what buyers pay and sellers receive. On widely-traded ETFs
the spread might be only a penny but that can go up to 50 cents on thinly-traded issues.
Therefore, you should to use widely-traded ETFs to get the best prices. In addition, you
can use “limit orders” to set maximum or minimum prices for buying or selling.
ETFs may work well for active traders. Because of the mutual fund scandals, fund families
have begun to add redemption fees, to cut down on short-term trading. ETFs don’t have
redemption fees. They do have transaction fees, though, so you should trade ETFs through
low-cost discount brokers.
For more information on ETFs, go to Web sites such as
