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Exchange-traded funds -- Page 2

It seems as though more companies are issuing ETFs every day, trying to capture a share of the burgeoning market. Among the biggest players are Standard & Poor's Depository Receipts, or SPDRs, usually referred to as Spiders; Vanguard's VIPERs and iShares, which are offered by Barclays Global Investors.

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For most do-it-yourself investors, the goal should be to build a diversified portfolio that meets your future financial needs and suits your risk tolerance.

"Consumers should start with a theme," advises Dan Dolan, director of Select Sector SPDRs, which takes the S&P 500 stocks and divides them into nine sectors.

"What are you interested in buying? Some sectors are easy. Do you have an opinion on the price of oil? What about health care? Do you believe in the demographic trends and growth potential of the industry? Then find a low-cost way to act on a theme."

Many companies issue similar, competing ETFs. One way to choose among them is to look at the expense ratio and find out how much it will cost you to own that ETF.

Let's use the health-care sector as an example. Here's a look at the expense ratios for SPDRs, VIPERs and iShares.

Health-care sector ETFs
Vanguard VIPERs (VHT)0.25%
Select Sector SPDR (XLV)0.25%
iShares (IYH) 0.60%

Why pay more than you have to? You could look at performance, but then you're looking at the past and, as we've all heard, past performance is not a guarantee of future returns. Besides, since ETFs track indexes, you'll see that they perform pretty much the same. The difference might be if one weighted Pfizer, for example, slightly heavier than Johnson & Johnson. If you look at the top 10 holdings of each of the ETFs, you'll see almost exactly the same stocks, although their weightings within each ETF may vary slightly. While all of the stocks within each fund matter, it's the top 10 that have the most ability to drive the fund up or down on any given day because of their heavier weightings.

Because of their tax efficiency, it's smart to use ETFs in a taxable account, but financial planners have found them to be good candidates for a variety of investments. Stephen Wightman, CFP with Wightman Financial Network, says his firm uses ETFs in Coverdell Education Savings Accounts.

"We don't use mutual funds in Coverdells. We use ETFs because of their low cost and transparency. It's very easy to design an age-based asset allocation with ETFs. We know how much of a particular sector to sell, or sometimes the whole sector, at a given time. Unlike mutual funds, you can analyze right down across sectors, weightings in small caps, large caps, duration of bonds -- you can't do that with mutual funds. Mutual funds give you the top 10 to 20 investments; that's not transparency.

"With the explosive growth rate, I forecast the day when people will wake up and smell the cappuccino. Why should I pay all this money for services I don't need or want? The mutual funds were in their heyday in the 20th century. ETFs heyday is now, the 21st century."

Whether you buy stocks, mutual funds or ETFs, one key to a sound portfolio is diversity. Holding large indexes such as the S&P 500 is a good bet for just about any portfolio. Do some studying of asset classes such as large, mid and small caps, and perhaps consider major sectors such as utilities, energy, health care and the like. You can get more specific with commodities and investments in countries or geographic regions, but many experts advise extensive research before making those commitments.

A final caveat, any time you're dealing with a basket of stocks, you run the risk of buying funds that contain overlapping stocks. ETFs list all the stocks they hold. Keep your portfolio truly diversified by reviewing those stocks and comparing them with other ETFs you may be considering.

Editor's Note: Laura Bruce owns several SPDR sector ETFs.

-- Posted: June 7, 2005




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