The New It Fund
Smarter than mutual funds, safer than stocks. Millions of Americans are in love with a low-cost, low-tax mutual fund alternative known as an ETF. Is this the fund of your future?
By Penelope Wang

(MONEY Magazine) – Recently Missy and Dave Welker realized they had to get serious about saving for retirement. Dave, 35, an orthopedic surgeon in Venetia, Pa., has the bulk of his money invested in his practice. Missy, 33, stays at home with their three-year-old twin girls, Hannah and Sarah. Their portfolio held just $45,000, mostly in IRAs. The Welkers knew they wanted to avoid big investment risks. "We're not looking to beat the market," says Missy. "And keeping costs low and reducing taxes is important to us, so more of our money stays invested."

A few years ago the Welkers would probably have opted for a portfolio of index mutual funds, which mirror the market with low costs and high tax efficiency. But instead the Welkers chose a newer type of investment--exchange-traded funds, or ETFs, which are index funds that you can buy and sell like stocks. With the help of financial adviser Brian Fisher in Washington, Pa., the couple diversified their IRA among three stock, bond and real estate ETFs, creating a lower-cost and more tax-efficient portfolio than they could have gotten elsewhere. Fisher, for one, no longer recommends traditional open-end mutual funds. "I became disenchanted with the fund industry, the mediocre performance and the poor disclosure," he says. He now puts his clients solely into ETFs.

The case for switching to ETFs is certainly compelling. ETFs give you the best of two investing worlds, the low costs and one-stop diversification of index funds, and the tax efficiency and flexibility of stocks. What's more, ETFs have opened up new markets to individual investors, making it possible for you to, say, take a flier on an industry without picking stocks on your own or paying a manager dearly to do so.

ETFs, in short, could change investing the way index mutual funds did a generation ago, and people are catching on. Although ETFs are a small part of the $8 trillion fund industry, assets are growing fast (see the chart on page 121). Last year assets ballooned by 51% to $227 billion, according to Financial Research Corp. By 2009, ETFs are expected to hold $812 billion.

But while many investors could profit with ETFs, the funds aren't for everyone. As with any hot new product, the hype can overtake the numbers. So to learn if ETFs are right for you, read on.

Why They're Hot

When you buy an exchange-traded fund, what you get is a basket of stocks designed to mimic the performance of a particular index. With more than 150 ETFs available, you can track everything from the whole U.S. stock or bond market to the biotech industry to Brazil. Some of the most actively traded ETFs carry colorful names, including Cubes (QQQQ), which follow the Nasdaq 100 index; SPDRs (SPY), proxies for the S&P; and Diamonds (DIA), which mirror the Dow Jones industrial average.

In every case, a key selling point is low operating costs. ETF expenses tend to be a smidgen lower than those of traditional no-load index funds--and way, way less than actively managed funds. Vanguard Total Stock Market VIPERs (VTI), for example, recently dropped expenses to just 0.07% of assets, less than even the ultralow 0.19% Vanguard Total Stock Market Index (VTSMX) charges.

What makes ETFs so different from mutual funds is that they trade like stocks. That means you can buy and sell ETFs during the day, giving you more control over the price you get. (By contrast, when you buy or sell an open-end fund, you have to settle for the price at the market's close.) You can also sell ETFs short or buy them on margin, just as with a stock, although those strategies are appropriate for only the most daring investors.

ETFs' stock-like traits pay off in other ways. Chief among them is with a lower tax bill. When you sell a regular fund, the manager may have to shed stocks to come up with cash. Also, market timers moving in and out of a fund may force it to sell shares to meet redemptions. All that selling can rack up taxable gains for you. With an ETF that doesn't happen, because you buy from other investors.

Where the ETF advantage really pays off is with funds that track one sector or a single country. With their lower costs and benchmark portfolios, ETFs can be better proxies for such markets than their mutual fund counterparts are. An ETF is often significantly cheaper than an actively managed sector fund--Vanguard Emerging Markets Stock Index VIPERs (vwo) charges 0.30% vs. 1.89% for the typical similarly managed fund.

Who Should Invest

Sounds great, so what's the catch? It's this: Every time you buy or sell an ETF, you must go through a broker and pay a commission or fee. Those charges can easily removethe low-cost edge of ETFs--particularly if you dollar-cost average. Say you invest $100 a month, and each trade costs you $10. You will end up losing 10% of your investment to commissions.

Clearly, the transaction costs can make ETFs unappealing. Still, as long as you're comfortable working with a broker or adviser, ETFs are an ideal choice, especially in these two situations.

» YOU HAVE A SIZABLE LUMP SUM TO INVEST. If you have a rollover IRA to stash away, or a windfall to allocate, ETFs work great. Over the long term, their rock-bottom expenses will more than make up for your one-time commission. (If you plan to tap that lump sum anytime soon, think twice, warns Fran Kinniry, principal at Vanguard. When you start making systematic withdrawals, you're probably better off in a traditional fund.) If you're investing outside a tax-sheltered plan, ETFs should save you money at tax time as well.

To build an ETF portfolio from scratch, stick with low-cost offerings from well-established ETF managers. Barclays (which runs iShares), Vanguard and State Street all have long track records managing indexes. The Welkers spread their IRA among three broadly diversified ETFs: iShares Russell 3000 Value Index (IWW), iShares Goldman Sachs Corporate Bond (LQD) and iShares Cohen & Steers Realty Majors Index (ICF). For help putting together your own portfolio, see the table at right.

» YOU'RE AN ACTIVE INVESTOR. If you like to put money in specific industries--energy, say, or financial services--single countries or narrow asset classes, ETFs can be the most cost-efficient way to do so. In some cases, an ETF is the only way: Most top small value funds, for instance, are closed to new investors, but Vanguard Small Cap Value VIPERs (VBR) tracks that market for an expense ratio of just 0.12%.

Some investors, moreover, like to shift money to take advantage of what they see as market opportunities, and ETFs make that easy too. For instance, many pros say that now is a good time to buy large growth stocks. A simple way to do that, says Morningstar analyst Dan Culloton, is to buy shares of Vanguard Growth VIPERs (VUG), which track the MSCI U.S. Prime Market 750 Growth Index.

Smart Ways to Buy

With ETFs hot and getting hotter, you're sure to hear more pitches for them--including special trading discounts from brokers. To enjoy the full promise of ETFs, you have to look past the hype and keep commissions down. So tailor your buying strategy to the kind of investor you are.

» IF YOU'RE INVESTING ON YOUR OWN FOR THE LONG TERM. For someone who buys a few ETFs a year and rebalances annually, you simply need to look for a low commission. You can pay as little as $7 a trade with deep-discount brokers, or $30 or higher with a full-service shop.

» IF YOU WANT PORTFOLIO ADVICE. Many planners and advisers now recommend ETFs along with stocks and funds, and ETFs can in fact be a cost-effective way to implement a pro's allocation plan. You'll often pay asset-based fees that cover the cost of buying ETFs, typically 1% or less of your portfolio. Just bear in mind that you should be getting comprehensive advice for that fee, not just trades.

» IF YOU BUY AND SELL FREQUENTLY. Several brokers are rolling out ETF gimmicks, but remember that your price per trade is still the bottom line. lets you make six automatic investments a month for $144 a year, or $2 a trade, but you have to buy at set times to get that rate (and on a $100-a-month investment, that eats up a painful 2% of your funds). With Ameritrade's ETF program, you can make unlimited trades for an annual fee: 0.50% of your assets if you have $20,000 to $99,999; 0.35% with $100,000 or more. On a $100,000 portfolio, that works out to 35 trades for $10 each. Even for such a heavy trader, that's in line with the best discount trade prices but not necessarily better.

Finally, the frenetic rise of ETFs means companies are rolling out new ones all the time. The more exotic funds may trade infrequently, or their indexes may hold illiquid stocks. Keep an eye on the prices of those offbeat ETFs, since their share prices may be well above or below the funds' value. Recently, for example, iShares MSCI South Africa (EZA) traded at a price that's 1.35% more than what its holdings are worth. And overpaying would defeat the whole purpose--and promise--of the low-cost world of ETFs.

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.

SOURCE: The funds.