The best investment in 10 years: Get in while you can

ETFs offer investors the best of everything - diversification, flexibility, low taxes and rock-bottom fees. But watch your wallet: Greedy promoters seem bent on spoiling the fun.

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By Penelope Wang, Money Magazine senior writer

Money 70
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(Money Magazine) -- If you could dream up the perfect investment, chances are it would look pretty much like an exchange-traded fund - or at least the way ETFs looked when they were introduced a decade or so ago.

The funds combine the simplicity and low costs of index mutual funds with the flexibility of individual stocks: With ETFs you can track broad-market indexes such as Standard & Poor's 500, gaining instant diversification. You pay super-low fees. You can trade the funds anytime the market is open. And you don't get hit with a tax bill (most of the time) until you sell.

Trust Wall Street - the folks who brought you triple-A-rated subprime mortgage securities - to mess up a good thing.

As investors pour money into ETFs, investment companies frantic to capture that business are rolling out more and more funds. The number of ETFs doubled last year to nearly 700, while assets jumped to $600 billion, up from $65 billion in 2000.

But we're not talking about a raft of plain-vanilla S&P index funds. Wall Street is madly engineering new, supposedly innovative ETFs that are complicated, risky and more expensive - just the reverse of what ETFs are supposed to be.

Some of these new ETFs use borrowed money to boost returns. Others track narrow slices of the market, such as nanotechnology. Just launched: a bond ETF designed to deliver high income rather than simply track an index. The manager - wait for it - is Bear Stearns (BS). And several other allegedly market-beating stock funds are on the way.

"The ETF industry makes most of its money from short-term traders and hedge funds betting on day-to-day market moves," says Don Phillips, managing director at Morningstar. "So the ETFs are moving further away from the needs of buy-and-hold investors."

Does this mean you should abandon ETFs entirely? Absolutely not. If you look beyond the wild and crazy offerings, there are still plenty of low-cost, reliable fund choices that can help you reach your long-term investing goals. (One caveat: You will probably have to pay a commission to buy an ETF, so they make sense only when you're investing a lump sum; if you're dollar-cost averaging, stick with no-load mutual funds.)

To identify the gems worth owning, though, you have to understand what is happening in the industry.

Wall Street is making a simple investment complicated.

Like index mutual funds, ETFs were designed to track traditional market benchmarks with long track records, like the Dow and the S&P 500. But to stand out from their rivals, lately providers have been cobbling together portfolios based on custom-designed indexes they hope will beat the market's performance.

The problem is that you have no past history you can use to judge the likelihood of success; often the newest funds just give you a convenient way to make a risky investment in whatever's hot at the moment (or worse, what was scorching five minutes ago).

Even when an ETF's strategy appears sound, it's hard to tell if it will really deliver. PowerShares FTSE RAFI (PRF), for instance, chooses stocks based on fundamental factors, such as the level of dividends and cash flow. Sounds smart. But over the past year, the RAFI hasn't outpaced the S&P.

"Any ETF that doesn't track a broad-market index is really following a particular investment strategy, even if the company calls it an index," says investment adviser Rick Ferri, author of The ETF Book. "So you need to understand the strategy and whether it's right for your goals."

Then too, in narrow corners of the market, where it's difficult to create an index of easily tradable stocks, you may not get what you expect. Take Claymore/Clear Global Timber (CUT), which aims to deliver the returns of timberland, an asset that institutional funds have relied on for diversification and strong returns. But the ETF can't buy land directly, so it instead invests indirectly through paper producer stocks, like International Paper (IP, Fortune 500). Yet studies show that paper stocks do not move in sync with performance of timberland. So far this year the ETF is down 13%.

What to do. To understand how a particular ETF invests, go to Morningstar.com or ETFguide.com for fund profiles and insights.

They're driving up costs.

No question, traditional index ETFs are still dirt cheap, typically charging 0.20% or less. Yet the average expense ratio for ETFs overall is much higher - 0.53% of assets vs. 0.35% in 2002.

What's the deal? Newer ETFs with complex strategies tend to incur higher management and transaction fees. Case in point: First Trust Large Core AlphaDEX (FEX), which picks S&P stocks based on potential gains, charges 0.70%. By contrast, iShares S&P 500 (IW), a conventional index ETF, costs just 0.09%. So far the two funds are neck and neck, but the more expensive ETF has to clear a higher hurdle to stay even.

If you buy a more exotic ETF, you may face hidden expenses too. As with a stock, the price you're willing to pay may be higher or lower than what the seller will accept, known as the bid/ask spread.

For ETFs that own widely traded stocks, such as those in the S&P, this spread may be a few pennies. But for less frequently traded ETFs, the spread can be two or three percentage points.

What to do. To keep costs low, stick with broad-market index ETFs. And avoid buying right after the market opens and shortly before the close, when the biggest bid/ask spreads tend to occur.

They're turning a low tax bill into a tax bite.

The original ETFs were the ultimate low-tax investment: Their stocklike structure, combined with the minimal trading needed to track a broad-market index, meant that these funds hardly generated any capital gains for investors.

Not anymore. Last year nearly 100 of the 554 ETFs tracked by Morningstar paid out taxable gains. Again, it's the new guys causing most of the trouble - ETFs that use borrowed money to leverage returns or follow strategies that require more frequent trading produced most of the gains.

What to do. Steer clear of ETFs that use leverage and funds whose strategies require more frequent trading than regular index funds. You can check a fund's tax efficiency in the ETF section at Morningstar.com.

The moral for investors: Keep it simple. Just because promoters are hawking ETFs with bells and whistles (and sequins and pearls) doesn't mean you have to buy them.

Says Ferri: "Just five or six funds can give you the basic diversification you need." Stick with low-cost index ETFs that track broad asset classes from providers like iShares and Vanguard, known for sticking closely to their benchmarks. (The ETFs at left fit the bill.) Then rebalance periodically to keep your asset mix on track. It's an elegantly easy strategy even Wall Street can't ruin. To top of page

A best-of-class ETF portfolio
These five ETFs stand out for their rock-bottom fees and strong records in tracking broad-market indexes. You can put together a simple yet fully diversified portfolio just by spreading your money among all five.
ETF THREE-YEAR RETURN1 EXPENSE RATIO SUGGESTED ALLOCATION COMMENTS
Vanguard Total Stock Market (VTI) 6.6% 0.07% 30% The entire U.S. stock market in a single fund
Vanguard REIT (VNQ) 12.7% 0.11% 10% Tracks returns for real estate investment trusts
Vanguard FTSE All-World ex-U.S. (VEU) N.A. 0.24% 20% Provides exposure to all stock markets outside the U.S.
Vanguard Total Bond Market (BND) N.A. 0.09% 30% A proxy for the performance of the U.S. bond market
iShares Lehman TIPS Bond (TIP) 7.2% 0.20% 10% TIPS are pricey now but do guarantee you'll beat or match inflation
Source: Notes: N.A.: Not applicable. 1Annualized returns of March 20. Source: Lipper
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