ETFs: 5 smart strategies
Exchange-traded funds can cut your investment costs, lower your tax bill and simplify your life. Just make sure you handle them with care.
By Walter Updegrave, MONEY Magazine senior editor

(MONEY Magazine) - When Exchange-Traded funds, or ETFs, came on the scene in the 1990s, they looked like the rarest of new financial products - one that actually made money for you instead of just your broker.

The earliest ETFs emulated the Standard & Poor's 500 and other broad stock indexes. They were like traditional index funds, only better, offering the same one-stop diversification but with lower fees and tax bills.

As more financial advisers and small investors caught on to ETFs' advantages, the companies that issue them began expanding beyond major indexes to narrower slices of the economy such as health care and technology.

Again, the benefits to you were clear: Avoid the high management fees of sector funds and lower the risk that comes with picking stocks. It's no surprise that investment pros were soon calling ETFs the coolest thing to come along since, well, index funds, and predicting that ETFs would revolutionize the way you invest.

And then things went from cool to, like, crazy.

Not content to limit themselves to major market benchmarks, ETF sellers began churning out dozens of funds aimed at ever smaller market subsectors, including leisure and entertainment, networking and semiconductors.

The number of ETFs has ballooned from just 30 with $34 billion in assets six years ago to more than 200 today holding more than $300 billion. ETFs are quickly becoming a means of turning long-term index fund investing on its head, providing an easy way to make risky investments in whatever slice of the market happened to be hot five minutes ago.

Wanna invest in a nanotechnology or clean-energy ETF? You can -- although it's debatable whether you should. Ditto for that euro ETF you can buy if you believe that the value of the dollar will fall.

That doesn't mean ETFs are now so dangerous that they're only for the foolhardy. You can still cash in on their original promise if you ignore the hype and instead focus on how they might fit into your long-term investing strategy.

With that attitude in mind, here are five smart ways you can make the most of ETFs.

PLAN 1: Put a windfall to work

Payoff: Save a bundle on fees ETFs can be an excellent way to invest a large sum such as a 401(k) or IRA rollover, a bonus or some other windfall. Use ETFs for the portion of the money that you want to put into U.S. stocks, where ETF annual operating expenses are typically lower than those of comparable index funds.

Yearly fees for ETFs that give you broad exposure to foreign markets, on the other hand, are higher than what you'd pay for an index fund, while fees for bond ETFs and index funds are about the same.

One caveat: Because ETFs trade like stocks, you buy them through a broker, which means forking over a brokerage commission. That can eliminate ETFs' cost edge if you're making frequent investments or putting in small amounts.

PLAN 2: Create the "me" mix

Payoff: Diversify across all your wealth-producing assets With ETFs you can customize your asset mix in ways that used to be possible only if you built a complicated portfolio from scratch - or paid an adviser to do so.

Say you work for a financial services company that gives you stock options as part of your pay package. Between your salary and your options, you've already got a big piece of your future riding on the financial sector.

Instead of buying a broad market index that would give you even more exposure to the banking industry, you can assemble a portfolio of industry sector ETFs that duplicates the overall market while toning down or even eliminating its financial component.

Similarly, ETFs allow you to stress a particular investing style. If you're in or nearing retirement, for example, you might want more exposure to value stocks since they tend to be less volatile than shares of fast-growing companies.

In that case you might consider adding an ETF that tracks an index of value shares. Conversely, if you're a younger investor willing to assume more risk for higher returns, you could invest in an ETF that focuses on growth stocks.

Sound confusing? It needn't be. The ETF Allocator tool at the iShares website (ishares.com) will help you create a customized mix.

PLAN 3: Go a little farther afield

Payoff: A safer portfolio Diversifying beyond the traditional asset classes of stocks and bonds is a way to dampen a portfolio's risk. If you wanted more protection from inflation, for example, you could add an ETF that invests in natural-resources stocks or in TIPS (Treasury Inflation-Protected Securities), government bonds whose payments rise with inflation.

You can also gain an extra measure of protection by buying ETFs that specialize in areas that may be quite volatile on their own -- such as gold and emerging markets stocks -- but that can actually dampen a portfolio's swings since they often zig when the stock market zags.

If, on the other hand, you want to get more current income from your portfolio, you can buy an ETF that homes in on dividend-paying stocks or REITs (real estate investment trusts).

Here are some options:

For inflation protection, try iShares Goldman Sachs Natural Resources Index (IGE (Research)) and iShares Lehman TIPS Bond (TIP (Research)).

For income, try iShares Dow Jones Select Div. Index (DVY (Research)) and Vanguard REIT VIPER (VNQ (Research)).

For still more diversification, try Vanguard Emerging Markets VIPER (VWO (Research)) and iShares COMEX Gold Trust (IAU (Research)).

PLAN 4: Round out what you've got

Payoff: Higher returns with less risk ETFs make it easy to plug gaps in your portfolio. Say you own a lot of big-company stocks but nothing at the small end. You know that properly diversifying your investments lowers your risk and raises your returns, but you're not up to sifting through thousands of small shares, or even hundreds of actively managed funds.

By buying a small-stock ETF, you instantly get all the small-company exposure you need for a bit less than you'd pay for an index fund.

Conversely, if you're a small-cap enthusiast who figures you won't find many compelling bargains among the well-researched ranks of big companies, you can buy a large-company ETF to fill out your portfolio.

Even if you like investing in individual stocks, ETFs may be able to play a role in your portfolio.

If you pick individual large-cap stocks... ...buy Vanguard Small-Cap VIPER (VB (Research)).

If you pick individual small-cap stocks... ...buy iShares S&P 500 index (IVV (Research)).

PLAN 5: Harvest a tax loss

Payoff: A big deduction come next April 15 ETFs can also help you do some tax maneuvering. Let's say you're sitting on a $5,000 loss in Dell shares but you still like the company's long-term prospects. You want to sell your stock to lock in the loss for the tax write-off, but you don't want to lose any appreciation in tech shares during the 31 days that the IRS "wash sale" rules say you must wait before buying back the stock.

Here's what you do:

You own a tech stock at a loss...sell the stock for the tax savings...buy a tech ETF...wait 31 days...sell the ETF...buy back the stock.

ETF Center: search in every category

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Market indexes are shown in real time, except for the DJIA, which is delayed by two minutes. All times are ET. Disclaimer LIBOR Warning: Neither BBA Enterprises Limited, nor the BBA LIBOR Contributor Banks, nor Reuters, can be held liable for any irregularity or inaccuracy of BBA LIBOR. Disclaimer. Morningstar: © 2014 Morningstar, Inc. All Rights Reserved. Disclaimer The Dow Jones IndexesSM are proprietary to and distributed by Dow Jones & Company, Inc. and have been licensed for use. All content of the Dow Jones IndexesSM © 2014 is proprietary to Dow Jones & Company, Inc. Chicago Mercantile Association. The market data is the property of Chicago Mercantile Exchange Inc. and its licensors. All rights reserved. FactSet Research Systems Inc. 2014. All rights reserved. Most stock quote data provided by BATS.
Market indexes are shown in real time, except for the DJIA, which is delayed by two minutes. All times are ET. Disclaimer LIBOR Warning: Neither BBA Enterprises Limited, nor the BBA LIBOR Contributor Banks, nor Reuters, can be held liable for any irregularity or inaccuracy of BBA LIBOR. Disclaimer. Morningstar: © 2014 Morningstar, Inc. All Rights Reserved. Disclaimer The Dow Jones IndexesSM are proprietary to and distributed by Dow Jones & Company, Inc. and have been licensed for use. All content of the Dow Jones IndexesSM © 2014 is proprietary to Dow Jones & Company, Inc. Chicago Mercantile Association. The market data is the property of Chicago Mercantile Exchange Inc. and its licensors. All rights reserved. FactSet Research Systems Inc. 2014. All rights reserved. Most stock quote data provided by BATS.