News Analysis
BusinessWeek
June 22, 2006
Link

Spread Your Bets in ETFs

Newfangled exchange-traded funds are hitting the market. But you may want to stick with a handful of simple, smart standbys for a diversified portfolio

It's a confusing time for investors. Wall Street has been twisting and turning, with the Dow Jones industrial average hitting a six-year high as recently as May 10, only to tumble 8% through June 13. Since then, the blue chip average has stubbornly rebounded 3.5%. Bulls and bears come and go, but exchanged-traded funds (ETFs) can provide a smart path to long-term diversification for buy-and-hold investors.

Despite the market's ups and downs, investors continue to pour money into ETFs, baskets of securities that trade throughout the day like stocks. Investors poured $14.9 billion into ETFs during the first four months of the year, according to the latest data from mutual-fund industry group Investment Company Institute. Over the same period, total ETF assets climbed 11.6%, from $296 billion to $334.9 billion.

MANY NEW OFFERINGS.  Lately, ETFs are getting more complicated. Once known as an easy, low-cost way to achieve broad diversification, ETFs are becoming increasingly focused, allowing institutional investors and other experts to gain exposure to ever-narrower sectors (see BusinessWeek.com, 05/05/06, "ETFs: Sliced, Diced and Razor-Thin"). Fund companies have rolled out 45 new ETFs so far this year, according to Boston-based Financial Research Corp.

More are on the way. On June 22, State Street Global Advisors will launch six new ETFs. The new portfolios are: SPDR Metals and Mining (XME ), SPDR Retail (XRT ), SPDR Pharmaceuticals (XPH ), SPDR Oil & Gas Equipment & Services (XES ), SPDR Oil & Gas Exploration & Drilling (XOP ) and streetTRACKS KBW Regional Banking (KRE ). Each will carry an expense ratio of 0.35%. "What we're providing is pure exposure to each one of these industries," says Greg Ehret, senior managing director at State Street.

Meanwhile, ProFunds introduced eight ProShares ETFs on June 21. Four will seek to double the market’s performance while the others will aim for the inverse of market returns. On June 26, Rydex Investments will unveil a set of six currency ETFs, called CurrencyShares: Australian Dollar Trust (FXA), British Pound Sterling Trust (FXB), Canadian Dollar Trust (FXC), Mexican Peso Trust (FXM), Swedish Krona Trust (FXS), and Swiss Franc Trust (FXF).

"PASSIVE STRATEGY."  While such funds could have many uses, some of the more exotic ones don't make sense for average investors, financial advisers say. "ETFs in my mind are a great structure for very prudent, long-term investing, as opposed to what some people use them for, which is short-term speculation," says John Gay, an adviser at Frisco Financial Planning in Frisco, Texas.

With more ETF choices than ever, which ones do most investors really need? "Somebody who is buying an ETF has accepted a passive strategy," says Alec Young, equity market strategist at Standard & Poor's Equity Research Services. "They're not trying to beat the market." This Five for the Money looks at five ETFs that give simple, smart diversification no matter which way the market swings.

1. Vanguard Total Stock Market VIPERs (VTI )
When it comes to U.S. stock exposure, Vanguard Total Stock Market VIPERs run the gamut. With more than 3,700 securities, this $71.7 billion portfolio invests in companies of all sizes, across a wide variety of sectors. Its biggest holdings include ExxonMobil (XOM ), General Electric (GE ), and Microsoft (MSFT ).

Simplicity is the main draw here, but Vanguard Total Stock Market's low cost enhances its appeal. The fund carries an expense ratio of 0.07%, compared to a category average of 0.21%, according to Chicago-based fund tracker Morningstar (MORN ). "That's a relatively low hurdle to jump to beat its peers over the long term," says Morningstar ETF analyst Dan Culloton.

This ETF also wears many caps. That is, it spans across companies of different market capitalizations. That's good, analysts say, because funds focusing exclusively on small-cap or large-cap stocks will have to sell holdings when a company reaches a certain size, incurring transaction costs. "If you buy a broader index, you avoid those commissions," says Rick Miller, CEO of Sensible Financial Planning in Cambridge, Mass.

2. iShares MSCI EAFE Index (EFA )
With the U.S. stock market covered, it's time to look overseas. iShares MSCI EAFE Index tracks the leading benchmark for foreign developed-market stocks, offering exposure to companies in Europe, Australia, and Asia. Rather than invest in each of the thousands of issues in the index, the fund holds about 800 stocks, including BP (BP ) and Toyota Motor (TM ).

The $28.5 billion fund has performed solidly tracking an index that few of its actively managed peers have been able to beat. iShares MSCI EAFE Index boasts an average annualized return of 24.67% over the past three years, slightly better than its style peers, according to S&P. The stocks represented by this fund make up about 46% of global market capitalization, notes S&P's Young.

However, with a price tag of 0.36%, this fund isn't the cheapest option among foreign large-blend ETFs. Investors could also cobble together the Vanguard European Stock VIPERs (VGK ) and the Vanguard Pacific Stock Vipers (VPL ) for similar exposure and an expense ratio of 0.18% on each. "But that requires a lot more work," says Culloton. Investors would have to maintain a proper allocation between the two ETFs, which along with the extra hassle might tack on additional trading costs.

3. iShares Vanguard Emerging Markets Stocks Vipers (VWO )
Don't be wary of emerging markets after the recent declines, which many market watchers consider a natural break from their strong run. Investors with a long time horizon should view these markets an important part of a well-diversified portfolio. The Vanguard Emerging Markets Stocks Vipers holds nearly 700 stocks, including Taiwan Semiconductor (TSM ), in this infamously volatile asset class.

Again, Vanguard's fund has a cost advantage over its competitors. The portfolio's 0.3% expense ratio is below the category average of 0.53%, according to Morningstar. The $9.6 billion ETF has only been available since March, 2005, but its corresponding traditional mutual fund, Vanguard Emerging Markets Stock Index (VEIEX ), has posted an average annualized return of 19.9% over the last five years, in line with its style peers.

Why invest in emerging markets now? "It still makes sense to have exposure to all portions of the global economy in your portfolio," says Morningstar's Culloton. Just be aware that emerging-market stocks tend to swing dramatically.

4. iShares Lehman Aggregate Bond (AGG )
Fixed-income ETFs are still relatively few and far between, so it's best to keep things simple. The iShares Lehman Aggregate Bond is the only ETF tracking the Lehman Aggregate, a commonly used benchmark for bond funds. It wouldn't be cost-effective to follow the entire index, so the ETF owns about 100 issues, including U.S. Treasuries.

The iShares Lehman Aggregate Bond has a 0.2% expense ratio, but its track record only extends to its launch in September, 2003. The fund posted an average annualized return of -0.72 for the one-year period ended May 31, slightly below its corresponding index.

Indeed, it's difficult for the fund to hew closely to the enormous Lehman Aggregate, and that concerns some analysts. Still, others say the ETF's low cost may be enough reason to invest in it rather than a traditional bond fund. "When you buy bonds it's all about expenses," says Sensible Financial's Miller. "First of all, 0.2% is pretty low. There aren't a lot of funds around that are less than that."

5. Vanguard REIT Index VIPERs (VNQ )
If you can tune out the housing market bears, the Vanguard REIT Index VIPERs is a cheap way to get exposure to real estate. The fund invests in real estate investment trusts (REITs), tax-advantaged companies that hold a portfolio of real estate properties. After all, there's much more to real estate than just the cooling residential-housing market.

Vanguard REIT Index tracks the MCSI U.S. REIT index, a broad benchmark with geographic diversification and exposure to various types of properties, including offices, apartments, and malls. Its corresponding traditional mutual fund, Vanguard REIT Index (VGSIX ), has averaged an annualized return of 19.07% over the past five years, in line with its style peers. Sticker shock won't be a problem with this ETF. Vanguard REIT Index VIPERs' expense ratio of 0.12% is well below its 0.33% category average. The fund is also "more efficient" than its rivals, Miller says. Just like a stock, remember that commissions can cut into returns when ETFs are traded frequently. These funds are best for buy-and-hold investors, and could make your financial life a lot less confusing.