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The virtue of ETFs
They're gaining in popularity -- here's how to use them in your portfolio.
December 12, 2003: 11:39 AM EST
By Walter Updegrave, CNN/Money contributing columnist

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NEW YORK (CNN/Money) - Where can I learn about ETFs and how to invest in them?

-Gino, El Paso, Texas

Let's begin with what ETFs, or exchange traded funds, are: a type of mutual fund that trades on a stock exchange much the same as any stock does.

At present, virtually every ETF is an index fund -- that is, it follows a specific stock or bond market benchmark -- although there has been talk of creating ETFs whose managers would pick stocks.

Like regular index funds, ETFs also tend to have low annual operating expenses.

At present, investors have more than 120 ETFs to choose from, ranging from ones that track widely followed indexes like the Standard & Poor's 500 index (which is made up mostly of large-company stocks) to the Lehman Aggregate Bond index (which represents a broad cross section of the U.S. bond market) to indexes of growth stocks and value stocks and international stocks and even stocks in certain industries and sectors (technology, financials, basic materials, etc.)

Within the past few weeks, the menu has expanded even more, as Barclay's Global Investors, the big Kahuna in ETFs, has introduced an ETF consisting of dividend-paying stocks as well as one that invests in TIPs, or Treasury Inflation-protected Securities, essentially Treasury bonds whose price and yields are pegged to inflation.

Benefiting from the fund scandal

ETFs have been getting more attention lately because of the mutual fund scandals.

Some mutual funds were letting market timers do rapid trading in and out of their funds to exploit price discrepancies between the value of the fund's overall portfolio and the value of the actual stocks in the fund.

Since ETFs trade throughout the day, their prices always reflect the current prices of the securities they hold, which means ETF shareholders can't lose money to market timers looking to exploit stale prices.

Many ETFs have another advantage over regular index mutual funds that stems from the unique way investors get into and out of these funds.

If an investor in a regular index fund exits the fund, the fund manager must sell some of the fund's securities to provide cash to the departing investor.

If the sale results in a profit, the fund must recognize a capital gain that is shared by all the fund's investors.

ETFs, on the other hand, have an innovative way of redeeming shares that allow them to pay departing shareholders without creating a taxable again. As a result, ETFs are often more "tax efficient" than regular mutual funds.

A couple of catches

Of course, there is a downside to ETFs. Since they trade like stocks, you must pay a brokerage commission when buying and selling them. If you're buying in small amounts, those commissions can seriously eat into your returns.

My feeling is that unless you're investing upwards of $10,000 or more, you're probably just as well off sticking to a conventional index mutual fund.

One other thing I think it's important for investors to consider about ETFs. Because ETFs can be easily traded and can allow you to invest in so many different sectors of the market, some people have come to regard them largely as trading vehicles, a way to pump up returns by jumping in and out of hot industries or asset classes.

I'm skeptical of investors' ability to pull of such a strategy.

So I think you're much better off thinking of ETFs as a relatively inexpensive and easy way to build a diversified portfolio of stocks and bonds that you will hold for the long term.

You can certainly build such a portfolio by mixing and matching various types of ETFs -- say, value and growth, small and large cap and different sectors.

Walter Updegrave
Mutual Funds

But I think it's much easier and ultimately a better strategy simply to stick to ETFs that track the broad market -- for example, the iShares Dow Jones Total Stock Market Index (or Vanguard's Total Stock Market VIPER) for the stock market and the iShares Lehman Aggregate Bond fund for bonds.

With just two investments, you're essentially getting the entire U.S. stock and bond market.

That's the Investing 101 version of ETFs. If you'd like to learn more about the nitty gritty of how they work and how you might integrate them you're your portfolio, I suggest you check out the iShares Web site and the ETF section of Morningstar's site.

But remember: just because ETFs offer the opportunity to slice and dice the market up into dozens of little pieces, doesn't mean it makes sense to invest that way.

Walter Updegrave is a senior editor at MONEY Magazine and is the author of "Investing for the Financially Challenged." He also answers viewers' questions on CNNfn's Money & Markets at 4:40 PM on Mondays.  Top of page

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