Getting the Most Out of Exchange-Traded Funds

Used Smartly, Niche Investments Can Spice Up Portfolios

Exchange-traded funds have become something like the Whole Foods of the financial marketplace, the trendy option for those who like to try the newest offerings.

But with more than 500 ETFs available, the choices can be more overwhelming than the variety of peppers in the produce section. And like the food at the organic-foods store, which can cost a premium, ETFs come with additional expenses that can be costly to your portfolio. Because of that, small investors might be wise to be picky, choosing only those funds that appropriately spice up their portfolios while leaving the rest to more-sophisticated money managers. In particular, investors in small, lightly traded funds could be whipsawed in markets as volatile as those of the past few weeks.

"They do bring some benefits to the table," says Sonya Morris, editor of Morningstar's ETFInvestor newsletter. "But it's important to approach them intelligently."

In many ways, ETFs are like old-fashioned index mutual funds. Managers put together a basket of stocks to fulfill an investment objective, using bread-and-butter options such as a total stock market or Russell 3000 fund, or more exotic ones, such as funds specializing in ophthalmology companies. But unlike mutual funds, ETFs trade on stock exchanges, allowing investors to buy and sell any time of the day.

In addition to more flexible trading, ETFs also have relatively low annual expenses and some tax advantages.

Despite their advantages, ETFs have drawn criticism from John Bogle, the mutual fund guru who founded Vanguard Group. "We've taken this wonderful, wonderful idea of indexing, and we've bastardized it," he says.

First, ETFs send the message that "owning the broad market index isn't enough," he said. "We want to own various sectors. It's not good enough to buy and hold them. We say, let's trade them." Those strategies, he argues, benefit brokers and advisers more than holders. Still, Bogle said there are "perfectly intelligent things to do with ETFs," mostly buying the big indexes and sticking with them. And, he says, "I'm not really against somebody trying with some of their money to outwit the market," though he said that should be a long-term investment, as well.

Specialized Investing

Almost $489 billion was invested in ETFs as of July, up 41 percent over the previous year, according to the Investment Company Institute. That's a small fraction of the trillions of dollars invested in mutual funds, but ETF options continue to proliferate. About 180 ETFs have been introduced this year, and more are on the way.

Whether the funds work for you depends on how often you invest and trade, how much you invest at once, and what you want in your portfolio.

Several financial advisers said they had waded into ETFs for very specific investments. Judy Redpath, a certified financial planner at Vista Wealth Strategies in Reston, with about $35 million under management, started using ETFs about two years ago for clients who wanted exposure to the energy and real estate sectors, precious metals, or commodities. Sometimes the ETFs make up as little as 1 to 2 percent of a portfolio.

"It's a great way to fill in around the edges," she said.

She said she especially likes that ETFs rarely generate capital gains distributions because of the way they are structured. "Most of my clients don't like paying taxes," she said. (They still have to pay taxes if they sell their shares at a profit.) Eric Hess of Alpha Financial Advisors in McLean generally prefers actively managed mutual funds over the passive index funds, believing that professional investors can blunt the impact of market downturns. Even so, he has put some clients in small-cap ETFs when the best mutual funds in that category were closed to new investments.