Cheatproof Funds Sick of scandal-ridden mutual funds? Exchange-traded portfolios may be the answer
By David Futrelle

(MONEY Magazine) – Let's give mutual funds some credit. They've made it cheap and easy for almost anyone to build a diversified, sophisticated portfolio. But as the fund trading scandal has revealed, they aren't perfect. One alternative that offers many of the same advantages without the potential for abuse is a curious little beast called the exchange-traded fund. ETFs are index funds that trade like stocks.

In the past, a lot of people--myself included--have been content to dismiss ETFs as day-trader toys. Unlike traditional mutual funds, ETFs can be traded fast and furiously and very often are. You can sell them short (bet on their going down), and you can buy them on margin. And so while traders and institutional investors have embraced ETFs, most of us buy-and-holders haven't.

But ETFs do offer some advantages for long-term investors--advantages the current fund mess has thrown into stark relief. As Lee Kranefuss, head of Barclays Global Investors' ETF business, puts it, "Large and small investors, active traders and buy-and-hold investors can peacefully coexist" in ETFs.

To understand what Kranefuss means, let's take a closer look at how traditional funds work--and where they sometimes don't. Most funds share all of their costs among hundreds or thousands of investors. But you're not only splitting your fund manager's salary with the other guy, you're also footing the bill for the other guy's trades. Shady market timers and law-breaking late-traders make this especially galling, but the fact is that any trading in and out of regular funds, innocent or otherwise, imposes costs on other investors.

Let's say investors decide, based on some intriguing news tidbit, to pile money into a traditional tech fund. The fund manager will have to go out and buy a heaping helping of stocks, or end up with a big cash stake that may slow returns. If those investors want their money back the next month, the manager will have to sell stocks to come up with the cash. Both sets of trades incur brokerage and other costs, which the whole fund pays. "You don't get a bill for it," says Kranefuss. "It's not part of the expense ratio. It comes out of your performance." These costs usually aren't huge--and they have even less impact on widely held, diversified U.S. stock funds like Fidelity Magellan and Vanguard 500 Index--but ETFs eliminate this risk altogether.

With ETFs the fund company never touches the shareholders' money, and they never have to come up with cash to meet redemptions. That's because you buy shares of ETFs not from the fund company but from other investors through the stock exchange. (Unlike their cousins, closed-end funds, ETFs generally trade at or very near the value of the stocks they own.) So ETFs are never forced by fast traders to buy or sell a stock. That's tax efficient too. Since ETFs typically sell stocks only when their index changes, capital-gains distributions should be small.


Abusive market timers in mutual funds have profited by taking advantage of the fact that the funds are priced just once a day and that those prices often don't reflect developments affecting markets in different time zones. This is impossible with ETFs because they are repriced constantly. Add to all this the fact that ETFs have low expenses--the average equity ETF has an expense ratio of 0.35% vs. 1.4% for old-fashioned funds, and Barclays' iShares S&P 500 ETF costs a razor-thin 0.09%--and they seem flawless.

Not quite. The biggest trouble with ETFs is that you have to pay a brokerage commission every time you trade. That means most investors can't use them for dollar-cost averaging. If you plan to put $50 a month in an ETF and you buy it through a discount broker charging $10 a trade, that's like paying a 20% commission. And you'll have to shell out again when you sell. So unless you have one of those fee-based brokerage accounts with free trades, ETFs are strictly for investing large sums. You also have to believe in index investing, because no one has figured out how to make ETFs work with active management. (And remember, most traditional index funds are also cheap and tax savvy.)

If these caveats aren't a problem for you, here's one way to build a sensible, low-cost portfolio based on ETFs. Start at the center, with a fund that gives you wide exposure to the U.S. market, like the iShares S&P 500 or the Vanguard Total Stock Market VIPERs. You can then use ETFs to boost your exposure to smaller companies with iShares Russell 2000, iShares S&P MidCap 400 or MidCap SPDRs. There are also ETFs for almost every major sector, from semiconductors to consumer staples. These can be useful tools for bringing the rest of your portfolio into balance--say, to offset your exposure to technology if you work at a tech firm--but they're best used sparingly.

The huge selection of international ETFs makes it easy to diversify overseas. Think Japan is finally on the mend? Place your bets on iShares MSCI Japan. Prefer Japan's rivals? Try iShares MSCI Pacific Ex-Japan. But most of us are better off concentrating on one or two broad international funds. Consider iShares MSCI EAFE, which tracks Morgan Stanley's Europe, Australasia and Far East index. You can supplement it with a fund tracking a country that you think holds particular promise or with iShares MSCI Emerging Markets.

ETFs aren't for everybody. But with their built-in advantages, they ought to start giving traditional funds a real run for their money--and for yours.