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Building the perfect ETF portfolio
Exchange traded funds have loads of advantages -- here's how to make them work for you.
June 6, 2005: 10:52 AM EDT
By Walter Updegrave, CNN/Money contributing writer

NEW YORK (CNN/Money) - Exchange-traded funds, ETFs for short, are one of those rare examples of a truly innovative products that has the potential to change for the better the way we invest.

By combining the low-cost and diversification of index funds with the tax efficiency and flexibility of investing in stocks, ETFs can give individual investors more control over their portfolios, and even a shot at better overall performance.

Although ETFs aren't new, it's only in the past couple that their popularity has soared.

Like any tool, however, ETFs aren't appropriate for everyone in every situation. If you're not sure if they're right for you, see 'The pros and cons of ETFs'.

If you're ready to take the plunge, though, read on.

ETF INVESTING STRATEGIES

Because of their unique design and flexible nature, ETFs lend themselves to a variety of investment strategies. Here's a rundown on the some of the different ways you might consider employing them:

Harnessing the power of the broad market. This is probably the simplest -- and in the minds of many investment experts including yours truly -- the most effective way to reap the advantages ETFs have to offer.

By simply buying and holding an ETF such as the Vanguard Total Stock Market Viper or the iShares Dow Jones Total U.S. Stock Market Index, you get the whole enchilada of U.S. stocks -- that is, an instantly diversified portfolio of that reflects virtually every publicly traded stock in the United States.

The same concept can be applied to bonds. By investing in, say, the iShares Lehman Bros. Aggregate Bond Index, you get the entire investment grade bond market in one portfolio -- government, mortgage-backed and corporates, the whole shebang.

Ditto for foreign exposure. The iShares MSCI-EAFE Index gives you a portfolio that includes stocks from all major developed nations outside the United States.

So with just three funds, you get a portfolio that reflects the U.S. stock and bond markets and that throws in broad international exposure as well. Talk about covering your bases.

Rounding out your portfolio. If you've been investing a while, you may already own stocks or funds that give you the exposure you need in certain key areas, such as large-company domestic stocks.

But perhaps you want to diversify into other areas where you feel less comfortable choosing individual stocks or mutual funds.

No problem. If you'd like to add, say, small-cap exposure, you could buy, say, the Vanguard Small-Cap VIPER or the iShares Russell 2000.

Or if you already had small-cap growth shares covered, but wanted to add small-cap value, you could invest in the Vanguard Small-cap Value VIPERs or iShares 2000 Value.

Or for that matter, you could add ETFs that track mid-cap or large-cap stocks or ones that focus on almost any industry or market sector, from consumer staples to consumer discretionary stocks to energy or materials companies to health care, information tech or real estate.

Similarly, if you wanted to limit your foreign holdings to stocks of a particular area, say, Europe or Asia, you could invest in the Vanguard European Stock Index VIPER or the Vanguard Pacific Stock Index Viper.

Emphasizing an industry or sector. Some investors want broad market exposure, but may also want their portfolios to be more heavily weighted toward certain industries. Let's say, for example, you think health care stocks will do better than other sectors because of looming demand for drugs and medical care from aging baby boomers.

Even if you already own a broad-based ETF or index fund that gives you exposure to the health care industry, you could boost your exposure by adding a health-care ETF.

Just remember, though, when you stray from the weightings represented in broad-based ETFs, you are effectively saying that you believe that the collective wisdom of all the investors in the market is wrong. Before you back up that assertion with your money, be sure you've got actual evidence, as opposed to a hunch or gut feel, to support your contrarian view.

Timing the market. By allowing you to move in and out of the entire market or specific segments with one quick trade, ETFs are a natural vehicle for market timing. If you believe the stock market is on the verge of major setback, for example, you can instantaneously dump a total stock market ETF or one pegged to the S&P 500 index and move your money to cash.

You can do the same for individual market sectors. If you think tech's growth is likely to slow but that financial companies are likely to pick up the slack, you can sell your tech ETF and move into an ETF of financial companies.

Indeed, there are enough sector and industry ETFs for you to play the sector-rotation game as often as you like. But again, keep in mind that by their nature these types of bets tend to be risky.

We know now that back in late 1999 and early 2000 would have been the ideal time to be getting out of growth stocks and tech shares and into bonds. At the time, however, most investors were doing just the opposite -- and ended up paying dearly.

Selling short and other fancy stuff. Because they can be traded like stocks, ETFs give investors access to a variety of strategies that would be much more difficult to pull off with mutual funds. If you were so conviced that stocks were heading down that you not only wanted to get out of the market but wanted to profit directly from its demise, you could do so by selling short a total stock market or S&P 500 ETF.

Or, you could make the same bet against a specific sector of the market -- energy, health care, growth stocks, whatever. Essentially, you would have your broker borrow shares of the ETF representing whatever index you felt was ready to plunge, sell that index and then wait to replace it with cheaper ETF shares after the index had fallen.

Conversely, if you felt the market or a specific sector was getting ready to soar, you could magnify your gains by buying an ETF on leverage: that is, borrowing from you broker to buy additional shares.

In effect, you would be using the broker's money to increase your bet on the sector.

Bottom line: with their advantages of low cost, tax efficiency and easy diversification, ETFs can help improve the performance of your portfolio, provided you use them in situations where they're appropriate and in a way that maximizes their advantages.

But if you insist on making risky bets or engaging in strategies with dubious chances of success, you can rack up losses that more than outweigh their advantages.

In short, ETFs can provide the opportunity to improve your investing game. Whether you take advantage of it is up to you.  Top of page

ETFs made easy
You can build an ETF portfolio with just a large-cap stock fund, foreign stock fund and bond fund. You can diversify further with midcap and small-cap funds, or with funds that throw off income.
Name (ticker) Expense ratio What's tracked
For your core portfolio
Vanguard Total Stock Mkt VIPERs (VTI) 0.07% All U.S. stocks
iShares S&P 500 (IVV) 0.09% 500 largest U.S. stocks
iShares MSCI EAFE Index (EFA) 0.35% Developed foreign markets
iShared Lehman Aggregate 0.20% U.S. bond market
For more growth potential (with more risk)
iShares S&P MidCap 400 (IJH) 0.20% Mid-size-company stocks
Vanguard Small-Cap VIPERs (VB) 0.10% Small-company stocks
Vanguard Emerging Markets
Stock VIPERs (VWO) 0.30% Selected emerging markets
For income or risk reduction
iShares Dow Jones Select Dividend (DVY) 0.40% High-dividend stocks
Vanguard REIT VIPERs (VNQ) 0.12% Real estate stocks
iShares Lehman TIPS (TIP) 0.20% Inflation-protected U.S. Treasury notes
Source: The funds.
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