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Beyond Stocks and Mutual Funds
Looking for the best way to diversify? You might try exchange-traded funds

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Related Items Table: Growth or Value? These Funds Go Either Way

With stocks finally gaining some traction, you may be thinking about getting active in the market again. But how? Mutual funds have appeal, but expenses can be high. Picking stocks is hardly the slam-dunk it was during the bull market. After all, who knows what company is the next Enron Corp.? The solution just may be the exchange-traded fund (ETF).

These securities are a twist on the plain old index fund. Like index funds, ETFs offer a cheap, simple way to capture the lion's share of the U.S. stock market. But you can do a lot more with ETFs than buy and hold a broad-based index, such as the Standard & Poor's 500-stock index. In fact, more than 100 ETFs now cover everything from the entire U.S. stock market to specialized niches, such as the utilities industry. You can take ETFs abroad as well: 20 focus on individual countries, with a handful spanning regions, such as Europe and Latin America. Like stocks and unlike mutual funds, ETFs trade on stock exchanges, and you can buy and sell them throughout the day for a commission.

If you are bullish on growth stocks--which have been out of favor for two years--or want to stick with value plays, ETFs give you a simple tool for putting your money to work. Likewise, if value stocks' superior performance in 2000 and 2001 has left your portfolio overexposed to that style, you can rebalance by adding a growth-oriented ETF to the mix.

Want to sell a beaten-down index fund at a loss to reap tax savings? Go ahead. To maintain your asset allocation without running afoul of Internal Revenue Service restrictions on repurchases, buy the comparable ETF as a replacement. "You're buying a completely different ticker symbol, but there's a 98% correlation to the original investment," says Thomas Mench, chairman of Mench Financial Inc. in Cincinnati, which specializes in ETFs.

If the small-cap value fund you have your eye on has received so much new cash that you're worried the manager might run out of good investment ideas, consider ETFs instead. Says Ross Levin, president of Accredited Investors Inc. in Edina, Minn.: "ETFs are an easy way to stay invested in a category."

With 18 ETFs devoted to value and growth, the difficulty is finding which are right for you. All feature low expense ratios and have good records when it comes to tracking their underlying indexes closely and keeping trading costs within reason.

Instead, the decision about which to buy comes down to your investment needs. The solution is simple if your goal is to capture the entire universe of growth or value. Indeed, the ETFs based on the Russell 3000 give you exposure to virtually all of the stocks within each investment style.

The choice gets trickier if you drill down to specific niches. Maybe you missed the midcap rally of the past two years. To fill that gap, you can pick an ETF based on the MidCap 400 index maintained by S&P--which, like BusinessWeek, is a unit of The McGraw-Hill Companies. But you might want to consider growth and value ETFs based on the Russell MidCap index, which includes more stocks than its S&P counterpart. When it comes to the biggest and smallest stocks, StreetTracks ETFs, which follow Dow Jones indexes, are another way to go.

Are there any differences? Indeed, there are, because S&P, Russell, and Dow Jones all define growth and value differently. That means the performance of index-based ETFs differs, too. In 2001, the gaps were especially wide, with the ETF tracking the large-cap S&P 500/Barra growth index--called the iShares S&P 500/Barra Growth--down 12.5%, vs. a 20.8% decline for the iShares Russell 1000 growth ETF, and a 25.7% fall for the StreetTracks U.S. Large Cap growth ETF. On the value side, the results were reversed, with the iShares Russell 1000 falling 6.2%, the StreetTracks U.S. Large-Cap value off 6.3%, and the iShares S&P 500/Barra value down 11.5%.

There are several reasons for the gaps. In 2001, differences in the way the index purveyors define growth and value caused S&P to categorize several of the year's worst performers--JDS Uniphase Corp. (JDSU ) is an example--as value stocks, while Russell and Dow Jones put them into growth indexes.

When sorting growth and value, all three indexers start by ranking stocks according to the ratio of share price to book value (a company's assets minus its liabilities). S&P stops there, putting stocks with high price-book ratios into the growth camp and affixing value labels to the half of the market's capitalization with low P-B's. Russell also considers analysts' estimates of each company's future growth rate, compiled by Thompson Financial/First Call. The Dow Jones indexes add factors including past and projected earnings growth rates, price-earnings ratios, and dividend yields.

With S&P, every stock is put into either a growth or value index. Russell, in contrast, allows the 30% of stocks that exhibit tendencies of both to be divided between the two. But Dow Jones excludes stocks that fall in the middle from either the growth or value indexes. That's 7% of its large-cap universe and 27% of small-caps.

What is right for you boils down to which index best meets your investment objectives. If you are confident that growth is ready to soar, you might pick from among the StreetTracks ETFs. They offer the most exposure to growth, since they exclude stocks that display value characteristics. However, if growth falls, the hybrid names in the S&P and Russell benchmarks could prevent the ETFs that track them from tumbling as far.

Packed with the most names, the Russell indexes tend to be more diversified. The Russell 2000 growth index, for example, contains 1,244 small stocks, vs. 221 for S&P's SmallCap 600/Barra Growth Index, and 370 for the Dow Jones small-cap growth index. However, there is a disadvantage to having more stocks. As the benchmarks are updated--once a year for Russell, twice annually for S&P and Dow Jones--the Russell indexes can experience greater turnover. That can trigger a tax bill when an ETF sells a winner, although that was not a big issue in 2001, since the indexes lost ground.

Russell's indexes also generally include smaller companies than those that make S&P's and Dow Jones's cutoffs. As a result, when small stocks outperform, the Russell-based ETFs tend to also.

True, the choices among ETFs are not simple. But compared with selecting investments from among thousands of stocks or mutual funds, ETFs are a relatively easy way to invest.

APRIL 2, 2002

By Anne Tergesen

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