All About Exchange-Traded Funds
Today’s Easy, Low-Cost Way to Invest

Tom Lydon - Trends Investments
David Yeske - Yeske & Co.

Introduced just over a decade ago, exchange-traded funds (ETFs) have attracted more than $200 billion in assets. It's easy to see why — rock-bottom fees, high tax efficiency and ease of trading make them an attractive alternative to mutual funds. What's more, ETFs were not affected by the mutual fund industry's trading scandals. With the recent introduction of bond ETFs, it now is possible to create an entire portfolio using these vehicles.

Here's what you need to know about investing with ETFs, plus model portfolios...

ADVANTAGES OF ETFs

Selection. ETFs track a wide variety of market benchmarks, such as the Dow Jones Industrial Average and the S&P 600 SmallCap Index. There are about 150 ETFs to choose from, covering investments from 20-year Treasury bonds to Italian stocks. Expected soon: ETFs that mimic an investment manager's top stock picks, instead of the stocks in an index. These actively managed ETFs — which could debut before year-end — may share many of the benefits of index-based ETFs.

Low costs and taxes. Like index mutual funds, ETFs' holdings change infrequently, so trading costs and capital gains tax are low. In addition, ETFs have lower administrative costs on average than even the cheapest index mutual funds. Example: The Standard & Poor's Depositary Receipts (SPDR) ETF, which tracks the performance of the S&P 500 Index, has an annual expense ratio of 0.12%, even less than the 0.18% of the famously inexpensive Vanguard 500 Index mutual fund.

Flexibility. No matter what time of day you trade most mutual funds, your price will be that day's closing price. Like stocks, ETFs trade constantly during market hours — a plus for active traders who hope to profit from intraday price changes. Because ETFs are treated like stocks, aggressive investors can sell them short — a strategy that lets you profit if the markets drop. You can't do that with index mutual funds.

DISADVANTAGES OF ETFs

You pay a commission. Because you must buy and sell ETFs through on-line or traditional brokers, they are best for investors who plan to invest $10,000 or more at a time. That's not a hard-and-fast number, but since each trade typically costs $10, fees become prohibitive for small ETF purchases.

They are not designed for periodic automatic investments. If you make many small purchases — for instance, with money taken from your checking account once a month — stick with no-load mutual funds.

CREATING AN ETF PORTFOLIO

The diversified portfolios on page 3 consist exclusively of ETFs.

Portfolios with conservative and moderate levels of risk are from David Yeske, a fee-only financial planner who devises strategies for buy-and-hold investors using index funds.

The aggressive portfolio is from wealth manager Tom Lydon, who takes a more opportunistic approach. His portfolio includes exposure to emerging-market stocks, which he thinks offer better value than US stocks. He chose an Austrian ETF as a proxy for Eastern Europe — there is no ETF for that region. Austrian companies stand to benefit from the region's growth.

A note on rebalancing: If you choose the conservative or moderate portfolio, adjust your allocations once a year to return to the original percentages. There is no need to rebalance the aggressive portfolio over the near term.

Bottom Line/Personal interviewed Tom Lydon, a 20-year veteran money manager and president, Global Trends Investments, Newport Beach, California (www.globaltrend.com)... and David Yeske, CFP, president of Yeske & Co., a fee-only financial-planning and asset-management firm in San Francisco (www.yeske.com). He is past president of Financial Planning Association.