Perfect your portfolio - and take a rest
Picking stocks is hard. ETFs ease the pain while still letting you benefit from the market's potential.
By Howard R. Gold, Money Magazine. Additional reporting by Carolyn Bigda

NEW YORK (Money Magazine) -- Some time after the market collapsed in the spring of 2000, you probably realized there's nothing simple about picking stocks.

To do it right, you need to make sure the company in which you're investing is well managed, financially solid and in an industry with decent prospects. That means plowing through earnings statements, finding good sources of independent research and assessing the integrity of the executive suite. Even stock ber-jock Jim Cramer, who pounds the table for his favorites on CNBC, urges viewers to spend an hour a week researching each individual stock they own.

That's a hefty part-time job, and there's even more to it: Should you sell a losing stock? Are you properly diversified? "People are overwhelmed," says Louis P. Stanasolovich, president and chief executive officer of Legend Financial Advisors in Pittsburgh. "They can't pick stocks on a day-to-day basis."

It's no wonder that the percentage of U.S. households that own individual stocks hasn't budged since 1999. And that so-called passive investing in index funds and one-stop investing through target-date retirement funds are gaining in popularity. They're a snap to use, and they work well for most people.

But they're also one-size-fits-all approaches that can have significant shortcomings. Plus, if you like investing, they're not much fun.

What would be great, then, is a way to bridge the gap between easy, plain-vanilla investing and difficult, old-fashioned stock picking.

Enter exchange-traded funds. ETFs are index funds that trade all day just as stocks do and cover everything from equities to bonds to commodities. Your broker can sell you ETFs tied to industries, precious metals, Standard & Poor's 500 index, Treasury bonds, the euro, or growth or value stocks.

"ETFs offer you the chance to be an active investor with less risk than if you picked individual stocks and bonds," says Brian S. Orol, president of Strategic Wealth Group in Raleigh, N.C. "They allow you to take 10% to 20% of a portfolio and let it be actively managed" in a simple, cost-effective fashion.

There are now more than 270 ETFs with total assets exceeding $350 billion trading on U.S. exchanges. That's a drop in the bucket compared with the $9.6 trillion invested in mutual funds, but ETFs have grown fourfold in the past five years. Here's how you can use them as a "passive aggressive" investor.

Looking for value

Traditional index funds tied to a total market index like the Wilshire 5000 should make up the core of most people's portfolios. But they can be pretty blunt instruments. That's because they're weighted by the stock market value of their components, so as stocks heat up, they make up an increasingly large portion of the index.

That is, until they turn cold. In the late 1990s, technology stocks became a bigger and bigger part of the market. When the stocks crashed, they took down index funds with them.

In addition, if you held such funds then, you had comparatively little invested in out-of-favor energy and basic-materials stocks, which became the stars of this decade. ETFs allow you to put money into market sectors that look undervalued without having to pick individual stocks or pay the high fees charged by mutual funds that specialize in an industry. Let's say you think that technology stocks, which have underperformed the broader market over the past five years, look like bargains.

You can put an extra sliver - say, 5% - of your equity holdings into the S&P Select Technology SPDR (XLK (Charts) or the iShares Goldman Sachs Technology Index ETF (IGM (Charts), which hold large tech names such as Apple Computer, Intel and Microsoft, as well as smaller companies. You'll benefit as tech's fortunes improve, but you won't have to bet on how Apple's iPod will fare against coming competition or on whether Intel will win its escalating chip war with AMD.

Or maybe you're convinced that the market as a whole is making a major turn. There's good reason for that belief. Large-company growth stocks were among the best-performing asset classes from 1994 to 1999. In every year since, they have been laggards.

But Money Magazine's Michael Sivy and other commentators have been arguing that these stocks are really undervalued now. If you agree, you might buy the iShares Russell 1000 Growth Index ETF (IWF (Charts) or the Vanguard Growth ETF (VUG (Charts), which own blue-chip warhorses including General Electric and Johnson & Johnson. (You can also buy mutual funds that track growth indexes.)

Widening your options

ETFs can also give you a stake in commodities, including oil, natural gas and industrial metals, as well as precious metals such as gold.

Academic studies suggest that an investment in commodities increases a portfolio's diversification, making it less likely that you'll suffer a catastrophic loss when stocks take a dive.

Prior to the advent of exchange-traded funds, there was no easy way for individual investors to invest in "stuff." As a substitute, you could have bought a natural-resources mutual fund, but these funds generally carry high expenses -and they invest in companies, not commodities.

Now, however, you can purchase the iShares GSCI Commodity-Indexed Trust (GSG (Charts), which has 74% of its weighting in energy products, or the PowerShares DB Commodity Index Tracking Fund (DBF (Charts), with a 55% concentration in energy. (Instead of buying and holding actual commodities, these funds try to mimic an index by trading futures contracts.)

Investor, know thyself

Of course, if you had been watching oil prices rise over the past year and then jumped into an ETF that tracks them this spring, you lost a big chunk of your investment in recent months. One of the problems with active investing is that amateurs and pros alike are given to chasing hot performers, only to get burned.

And ETFs certainly make that easy to do. If you can't check those impulses, stick with a passive indexing approach. ETFs also aren't a good way to regularly invest small amounts of money because you have to pay a brokerage fee to buy them. Even if you're paying just $10 a trade at a discount brokerage, you'll lose 5% of a $200 investment to a commission.

And you won't hit home runs with exchange-traded funds. There is no Google ETF.

On the other hand, you also are not going to face the kind of meltdown that even blue-chip stocks occasionally undergo. In mid-July, for example, Internet stalwart Yahoo reported earnings in line with Wall Street's estimates as revenue surged 28%. But the company also announced a delay in a new system to serve online search ads, a field in which Yahoo trails Google.

The result: Yahoo's stock tanked 22%, its biggest one-day drop ever. Overnight, shareholders found themselves $10 billion poorer. (The stock also dropped 11% one day in September when it warned of weak third-quarter advertising sales.)

This kind of volatility makes it hard to stay the course as an active investor and gives rise to the kind of frenetic buying and selling that hurts you in the long run. So it is worth remembering that on the day Yahoo plunged, ETFs tracking technology indexes barely budged.


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