ETFs: A user's guide

Exchange-traded funds are one of Wall Street's hottest products. Do they make sense for you? Fortune's Katie Benner explains the ups and downs.

By Katie Benner, Fortune reporter

(Fortune Magazine) -- There's nothing Wall Street loves more than having a new product to peddle, and exchange-traded funds (ETFs) have been one of the most popular offerings of the new century.

Last year no fewer than 156 new ETFs hit the market; today, the total is about 400. The pace is set to pick up this year when the Securities and Exchange Commission streamlines the approval process. And ETF sponsors are hoping to make them available in 401(k)s, which would give them a much broader audience.

So with all the hoopla surrounding ETFs, you may feel you have to have one - or collect the whole set! But as you would with any novelty from Wall Street, give ETFs a careful look before plunging in.

ETFs are similar to mutual funds in that they hold a basket of stocks, giving you a diversified portfolio with just one purchase. But unlike mutual funds, they are traded on exchanges, where you can buy and sell them throughout the day, like stocks.

Despite their rapid growth, ETFs still claim a relatively small share of investors' dollars. Chicago research firm Morningstar says there is about $419 billion in ETFs, vs. $7.5 trillion in the roughly 6,500 conventional stock and bond funds.

Low cost is a key to ETFs' appeal. Because ETFs are passively managed - they all track indexes of one sort or another - annual management fees are minimal. The average ETF has a 0.41 percent expense ratio, vs. 1.35 percent for an actively managed mutual fund and 0.74 percent for an index mutual fund. ETFs are also considered more tax-efficient than mutual funds, a factor that can boost returns.

The first ETFs tended to track broad benchmarks, like the popular SPDR (Charts), which is pegged to the S&P 500, and the Nasdaq 100 (Charts), which follows the index of the same name. Now that the major bases are covered, ETFs are becoming increasingly focused, offering access to highly specific - and sometimes obscure - market niches, from single countries to futures prices to stocks with low price-to-book ratios.

Some of these specialized portfolios can be useful, but the candy-store approach can lead to investor indigestion. "Who needs an ETF tracking the companies with the most patents?" says Ronald DeLegge, editor and publisher of etfguide.com. "You can index anything, but that doesn't necessarily mean you want to."

Indeed, ETFs have distinct pluses and minuses. For someone trying to get started without a lot of money, one big advantage of ETFs is the lack of a minimum investment. The most popular index fund, the Vanguard 500 Index, requires an initial investment of $3,000. But you can buy as little as one share of the SPDR for $141.

Of course, that doesn't include the commission you pay when you buy and sell shares in an ETF - and that's a minus. While using a discount broker can keep your transaction costs relatively low, if you're planning to make regular modest investments, you're better off with a no-load mutual fund.

ETFs also allow for instant gratification, since you can trade them whenever the markets are open. But for long-term investors, that's hardly a necessity. So don't get carried away by the hype. ETFs can be a versatile, low-cost vehicle for index investing, but don't feel you need to check out every new model that comes off the Wall Street assembly line.

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