Smart Strategies for ETFs

These vehicles can be a useful part of an investor's tool kit, but there are drawbacks. Here are some tips for using ETFs

by Ben Steverman

Already quite popular with traders and sophisticated investors, exchange-traded funds, or ETFs, have hit the big time in the past year.

The popularity of these vehicles—funds that track indexes but can be traded like stocks—is evident from the pace at which the industry is rolling out new funds.

Another sign: the amount of investor dollars that have flowed from traditional mutual funds into ETFs. In 2007 investors plowed $94.5 billion into equity mutual funds, but that was surpassed for the first time by the $125.5 billion that flowed into equity ETFs, according to TrimTabs Investment Research. In 2008, meanwhile, bearish investors have pulled $54.1 billion from equity mutual funds but only $8.4 billion from equity ETFs, TrimTabs says.

The most popular ETFs closely track the movements of broad stock indexes such as the S&P 500 or closely watched sectors like financial stocks. But an explosion of new funds now slices and dices the market in hundreds of ways.

Tough to Navigate

Morningstar (MORN) tracks almost 700 ETFs. Some vehicles track narrow industries such as timber, water, or neuroscience. They provide broad exposure to international stocks, or they focus exclusively on particular countries or continents. Some ETFs fall when the rest of the markets rise, or vice versa (BusinessWeek.com, 4/2/08), while others double your exposure, so you get twice the gain or loss on a particular index.

Commenting on the sheer variety of ETFs out there, Atlanta financial planner Bobbie Munroe of Fraser Financial says: "There is a point where this becomes ridiculous." Nevertheless, even superspecific ETFs can help investors in some cases, she adds.

Investors may welcome more choices, but the world of ETFs has reached such a level of complexity that it's getting tough to navigate. There are significant dangers and costs for the investor who chooses ETFs unwisely.

We asked financial planners such as Munroe for advice on using ETFs. Here are several they offered:

Watch the Taxes and Fees

Tax efficiency and a low expense ratio are the main reasons many planners recommend ETFs. But not all ETFs offer these benefits: Some have high expenses—though they're almost always lower than a comparable mutual fund—and others, especially specialized ETFs (such as those that trade commodities), might not shield you from taxes. Still, if you're trying to choose between a basic ETF and a basic mutual fund, the ETF offers tax advantages. So, a mutual fund will probably perform better in a tax-protected account such as an individual retirement account or 401(k).

Beware the Less Popular ETFs

An esoteric, narrowly focused ETF gives you convenient exposure to a subsection of the market that was previously tough to obtain. But these vehicles have a host of problems that make them better suited for traders than investors, financial planners say. If an ETF is traded less often, it's harder to sell at the same price you bought it. Also, managers of some lightly traded ETFs have had a hard time accurately matching the returns of their underlying indexes, a problem called tracking error.

Stick to the well-traveled highways of the ETF world. Timothy Brown of Brown Wealth Management in Minnesota recommends three popular ETFs that offer "a very simple portfolio" at "rock-bottom prices:" The Vanguard Total Stock Market ETF (VTI) offers U.S. stock exposure. The FTSE All-World ex-US ETF (VEU) tracks international stock markets, while the Total Bond Market ETF (BND) provides your appropriate level of bond exposure.