S&P's Selection of Solid ETFs

To help investors diversify their assets, Standard & Poor's has come up with a model portfolio of nine exchange-traded funds

The number of exchange-traded funds in operation is tiny compared to the number of mutual funds available to investors. Still, it's possible to put together a diversified portfolio using only a handful of ETFs.

An ETF that tracks the S&P 500-stock index alone would provide broad exposure to the equity market, says David Braverman, a vice-president with Standard & Poor's portfolio services unit. Investors could then add one fund that tracks an index of small-cap stocks and another that does the same for midcaps, he says.

SLIM PICKINGS. Very few ETFs invest in fixed-income securities, "but I think you can put together an adequate portfolio with what's out there," Braverman says.

Of the 187 ETFs in operation as of the end of October, only six tracked bond indexes, according to the Investment Company Institute, the fund industry's trade organization. Of the remainder, 132 invested in domestic stocks, and 49 bought shares of foreign companies. By comparison, more than 8,000 mutual funds are on the market, excluding money-market funds.

S&P has put together a suggested portfolio of nine ETFs that invest in domestic and foreign stocks and U.S. bonds. A recommended list of funds and percentage of assets in them recently appeared in S&P's weekly investing newsletter, The Outlook (see table below).

GLOBAL REACH. For exposure to the S&P 500, the model portfolio includes S&P Depositary Receipts (SPY ), or SPDRs. Midcap and small-cap stocks are represented by S&P MidCap Depositary Receipts (MDY ) and iShares S&P SmallCap 600 Index Fund (IJR ). The iShares fund is a product of Barclays Global Investors.

The list includes four Barclays ETFs that invest overseas: the iShares MSCI EAFE Index Fund (EFA ), the iShares MSCI Pacific Index Fund (EPP ), the iShares MSCI Emerging Market Index Fund (EEM ), and the iShares MSCI Japan Index Fund (EWJ ).

Bonds in the portfolio are represented by two other Barclays ETFs, the iShares Lehman Aggregate Bond Fund (AGG ) and the iShares Lehman 1-3 Year Treasury Bond Fund (SHY ).

These ETFs are aimed at providing adequate diversification, Braverman says.

SECTOR-FUND RISK. In addition to the S&P 500 SPDR, investors seeking broad exposure to domestic stocks could also consider the iShares S&P 1500 Index Fund (ISI ) or the iShares Russell 3000 Index Fund (IWV ), suggests Rosanne Pane, a mutual-fund strategist at S&P.

Investors can supplement core ETF holdings with sector funds that focus on selected groups of businesses or industries, Braverman and Pane say. These funds can take off when a sector gets hot, as energy companies have been recently and technology companies were in the late '90s. But they can cool just as rapidly.

Because of their potential volatility and risks, Pane thinks investors should limit their investments in sector funds to 5% to 10% of their total assets. "It would be sort of a cardinal error to make a sector ETF the centerpiece of your portfolio, or the only holding in your portfolio," Braverman advises. "By nature, they're not intended to be diversified."

A Model ETF Portfolio

Allocation	Asset Class/Investment Style	ETF (Ticker)	Expense Ratio	One-Year Total Return (through 9/30/05)
45%	U.S. STOCKS
35%	Large-Cap Blend	S&P Dep Receipts (SPY)	0.12%	12.1%
6%	Midcap Blend	S&P MidCap Dep Receipts (MDY)	0.25%	21.8%
4%	Small-Cap Blend	iShares S&P SmallCap 600 Index Tr (IJR)	0.2%	21%
20%	FOREIGN STOCKS
9%	International	iShares MSCI EAFE Index Tr (EFA)	0.35%	25.4%
4%	Japan	iShares MSCI Japan Index Fd (EWJ)	0.84%	26%
4%	Pacific	iShares MSCI Pac Index Fd (EPP)	1.5%	33.6%
3%	Emerging Markets	iShares MSCI Emerg Mkt Index Fd (EEM)	0.78%	49.7%
20%	BONDS
10%	U.S. Debt	iShares Lehman Aggregate Bond Fd (AGG)	0.2%	2.5%
10%	U.S. Short-Term Debt	iShares Lehman 1-3 Yr Treas Bond Fd (SHY)	0.15%	0.8%
15%	CASH	U.S. 6-Month Treasury Bills

READER COMMENTS

Diennor is a reporter for Standard & Poor's Fund Advisor

All of the views expressed in this research report accurately reflect the research analyst's personal views regarding any and all of the subject securities or issuers. No part of analyst compensation was, is or will be, directly or indirectly related to the specific recommendations or views expressed in this research report.
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Any advice, analysis, or recommendations contained in articles labeled "Insight from Standard & Poor's" reflect the views of Standard & Poor's, which operates separately from and independently of BusinessWeek Online. It is possible that BWOL may from time to time publish information that is not consistent with advice, analysis, or recommendations that are published by Standard & Poor's. Standard & Poor's and BusinessWeek Online are each units of The McGraw-Hill Companies, Inc.

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