Increasingly popular exchange-traded funds (ETFs) offer low expenses, tax efficiency, transparency, and trading flexibility.
ETFs generally fall into one of three categories.
Traditional index ETFs. These have the advantages and disadvantages of following an index that’s weighted by companies’ market capitalization. They can rise and fall sharply, as S&P 500 funds have done in the past decade.
Fundamental index ETFs. PowerShares’ FTSE RAFI US 1000 Portfolio, for example, tracks an index that weights companies by sales, cash flow, book value, and dividends, rather than by the price of company shares. Such ETFs assert they put more emphasis on underpriced companies and less emphasis on overpriced companies.
Semi-active ETFs These ETFs follow indexes that are designed to select companies based on investment merit. PowerShares Dynamic Market Portfolio and PowerShares Dynamic OTC Portfolio are in this category; both have performed well in the three years they’ve been on the market.
Although it’s too soon to tell whether non-traditional ETFs will be superior performers, you might want to include some of them in a diversified portfolio.