Steven Goldberg, Contributing Columnist, Kiplinger.com
Kiplinger.com
Wednesday, July 23, 2008; 12:00 AM

Many of the exchange-traded funds and exchange-traded notes being marketed these days make about as much sense for your finances as an all-nighter at the craps tables in Atlantic City. For example, DB Commodity Double Short ETN promises to give you twice the inverse of the daily moves in prices of a commodity index. Bullish on cocoa? Look to iPath DJ AIG Cocoa TR Sub-Index ETN.

The proliferation of silly products like these threatens to obscure the good news about ETFs -- that they offer you a low-cost way to invest in major market indexes. If you stick to inexpensive, broad-based ETFs, you will get a sensible alternative to index mutual funds. Inexpensive generally means annual expense ratios of 0.20% or less. You have to pay brokerage commissions to buy ETFs, so don't use them if you're investing small amounts on a regular basis.

Here's how I'd allocate my money among ETFs in today's market. For your bond money, use Vanguard Total Bond Market (symbol BND) if you're investing in a tax-deferred account or are in a low income-tax bracket. Expenses are only 0.11%.

Otherwise, stick to a mutual fund, Vanguard Intermediate Term Tax Exempt ( VWITX), which totes an expense ratio of just 0.15%. I'm not sold yet on muni ETFs because many munis are thinly traded.

Start by putting 40% of your stock money in Vanguard Total Stock Market ( VTI). Its expense ratio is a mere 0.07%. It tracks the MSCI U.S. Broad Market Index, which covers essentially the entire U.S. stock market. Larger companies predominate, as they do in most broad-based stock market indexes.

Stocks of large companies are cheap relative to small companies. That's unlikely to continue. Indeed, large-company stocks have been declining less than small-company stocks over the past 12 months -- although the stocks of small companies did better than those of large companies in the first half of this year. Prior to last year, small-company stocks had beaten large-company stocks in seven of the previous eight years. Consequently, small-company stocks actually trade at higher price-earnings ratios than large-company stocks. Now that large-company stocks are in ascendance again, they'll likely keep besting small-company stocks for several years.

Next invest 20% in Vanguard Mega Cap 300 Growth Index ( MGK). This fund invests in the largest growth stocks in the country. The median market value of its stocks (share price times number of shares outstanding) is $46.3 billion. Fully one-third of assets is in fast-growing tech stocks, yet the average P/E of the stocks in the fund is a thrifty 19 based on earnings over the past 12 months. Its expense ratio is 0.13%

When large-company stocks do well, mega caps (the largest of the large) often do the best of all. What's more, growth stocks, like large-company stocks, have been out of favor ever since the tech bubble collapsed in 2000-2002. Many large tech stocks, as well as other fast-growing large companies, sell at modest prices relative to their earnings and other measures.

Put 15% in Vanguard FTSE All-World ex-U.S. ( VEU). Don't worry about the big mouthful of a name. This ETF gives you the world's stock markets -- except the U.S. It has an expense ratio of 0.25%

To raise your stake in fast-growing emerging markets, invest 10% in Vanguard Emerging Markets ( VWO), which has an expense ratio of 0.25%. The future lies with emerging markets; you don't want to shortchange them.

Invest another 10% in Vanguard Extended Market ( VXF). This fund invests in all U.S. stocks except large caps and has an expense ratio of just 0.08%. Just because I think large caps are the place to be in the next couple of years, doesn't mean I'm willing to invest all my money that way. Investing will make you humble -- if it hasn't already.

The final 5% goes into ishares MSCI EAFE Growth Index ( EFG). An expense ratio of 0.40% makes this the priciest ETF in the portfolio. But it gives you valuable exposure to fast-growing, large companies based outside the U.S.

When you look at the overall portfolio, 73% is in large-company stocks, 18% in midsize-company stocks and 9% in small-company stocks, according to Morningstar. Thirty-eight percent is in growth stocks compared with just 27% in value stocks. Fully 29% of the stocks are overseas, including 10% in emerging markets. I think that's much-needed international diversification.

Because growth stocks and emerging markets stocks tend to be riskier than other stocks, the portfolio is 13% more volatile than Standard & Poor's 500-stock index.

The blended expense ratio of the portfolio is a miniscule 0.14%. It would be harder to invest at lower cost.

This is hardly a buy-and-forget portfolio. Over the long haul, small-company stocks and so-called undervalued stocks have tended to beat large-company stocks and growth stocks. So some adjustments will inevitably be necessary, although perhaps not for a couple of years.

Steven T. Goldberg ( bio) is an investment adviser and freelance writer.