Smart Strategies for ETFs

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ETFs or Index Funds?

ETFs generally have lower expense ratios than index funds. But investors often can buy shares of index funds without paying a fee, while ETFs are bought like stocks, so investors must pay a trading fee. In other words, ETFs are generally cheap to hold but can be expensive to buy, while index funds are easy to buy but slightly more expensive to hold.

If you invest a lot all at once, the ETF is probably a better choice. If your investing is spread over time—just a small portion of each paycheck, for example—then index funds might be cheaper. But, says Adam J. Leavitt, a Tulsa planner at Hogan & Slovacek, don't forget that many brokerage firms charge big fees for mutual fund purchases. To see what makes sense, investors need to do their own math based on their own circumstances.

Resist the Temptation to Trade

ETFs are easy to buy and sell, which make it tempting to try to gamble your way to riches by buying and selling them frequently. That's unlikely to be a winning strategy for individual investors, says A. Todd Black of Dogwood Capital Management in Cumming, Ga. "The danger is that people are thinking Vegas instead of long term," he says.

Don't Bet Too Much on a Narrow Strategy

Jim King, of Balasa Dinverno Foltz, a private wealth management firm in Itasca, Ill., says ETF managers, by offering ever narrower choices, are "slicing and dicing way too tightly." These narrow indexes tend to be more volatile, and it's not easy to figure out what you're holding in a narrow ETF.

Is an ETF really what it advertises? King recommends keeping it simple. "We want to invest in what we know," he says.

Black says he sometimes recommends ETFs focused on a particular sector, but he generally keeps them to 1% of a portfolio. Investors may want to buy a financial sector ETF to bet on a revival of banking stocks, for example. But, he says, they need to realize they're probably already heavily exposed to the financial sector in other broad index holdings. Look closely at ETF holdings, he says. You "really need to look under the hood and see what you've got."

The ETF craze is likely to cool off eventually. The supply of ETFs already may have swamped demand, especially as investors face the prospect of a long bear market. But even if investor enthusiasm ebbs a bit, there's no doubt ETFs—with their convenience, tax benefits, and low fees—are part of a strategy that's here to stay.

Steverman is a reporter for BusinessWeek's Investing channel.