Better Living Through ETFs

Why pay others to manage your money? Here's how you can build an entire portfolio with exchange-traded funds.

ABOUT SIX YEARS ago, Mark Wiener hit a wall -- with mutual funds, that is.

An avid investor since 1986, Wiener, 37, found that his mutual-fund holdings weren't nearly as successful as the stocks and bonds in his portfolio. Lackluster performance aside, he bristled at the glaring disconnect between managers' compensation and fund performance. And the expenses? Fuhgeddaboudit: "The 12b-1 fees drove me nuts," he says. Frustrated with the lack of control he could exert with funds, he abandoned them entirely, outside of his 401(k).

Wiener's discouragement with mutual funds came long before New York Attorney General Eliot Spitzer exposed the ugly underbelly of the fund world. Performance issues alone prompted the Raleigh, N.C., resident to add some exchange-traded funds, or ETFs, to his portfolio mix.

ETFs, of course, are baskets of securities that track indexes, but trade like stocks. They're tax efficient, inexpensive (because they're not actively managed) and offer greater transparency than most mutual funds. Since ETFs have to be purchased through a broker, however, they carry transaction costs.

Exchange-traded fund flavors are varied. There's the Nasdaq-100 Index Tracking Stock, or Cube (QQQ), which tracks the largest stocks in the Nasdaq; the Standard & Poor's Depositary Receipt, or Spider (SPY), which follows the S&P 500 index; and Diamond (DIA), which tracks the Dow Jones Industrials. But those are just the best known -- there's an ETF for just about every kind of index. Even mutual funds are beefing up their offerings. Late last year, Fidelity launched its Nasdaq Composite Index (ONEQ). In January, Vanguard added 14 new ETF products, so-called Vipers (Vanguard Index Participation Equity Receipt Shares), to its original stable of two.

While many investors are still learning the ABCs of ETFs, the vehicles have become increasingly popular in recent years, say financial planners. John Kvale, a certified financial planner and president of Dallas-based J.K. Financial, says three years ago, only 2% to 3% of his 100 or so clients owned ETFs. Now, that number is closer to 15%. Whether folks are looking to squeeze a bit more performance out of their portfolios or revamp them entirely, ETFs can be helpful tools.

Brian Orol, a certified financial planner and president of Raleigh, N.C.-based Strategic Financial Planning Group, says ETFs offer some terrific -- and simple -- investing possibilities. Take the iShares Goldman Sachs InvesTop Corporate Bond Fund (LQD), which is an index of corporate-grade bonds. This, says Orol, is a better place to park cash than a money-market fund. While the iShares fund carries some interest-rate risk, as does any bond product, it boasts a yield of more than 4%. That's at least four times what a top-yielding money-market fund is paying these days, at little additional risk.

Another alternative to a money-market fund, and a good way for beginners to dip their toes in the ETF pool, is the iShares Lehman 1-3 Year Treasury Bond Fund (SHY), according to Orol. The ticker symbol is appropriate, he says, since it's a risk-shy investment. During the past year, it returned 1.82% -- slight, but far better than the measly returns of money-market funds.

One school of thought maintains that investors can achieve all of their asset-allocation goals with just one stock and one bond holding -- such as the Vanguard Total Stock Market Vipers (VTI) and the iShares Lehman Aggregate Bond Fund (AGG) -- whose weightings can be adjusted based on age, risk tolerance and any number of other factors. Not surprisingly, such a simplistic approach doesn't sit well with some pros. Orol, for one, shuns building portfolios solely using ETFs. He recommends them in conjunction with active management of stocks and bonds.

But other advisers say investors are beginning to cotton to the idea of ETF-only portfolios. J.K. Financial's Kvale says one of his new clients will probably opt for one. Not only is the client sensitive to expenses, but the family has little interest in outperforming the market. "They just want tried-and-true asset allocation at the least expense possible," says Kvale. "And in this case, (ETFs) meet their goals."

Given the ongoing concerns about mutual-fund fees and transparency, this could become a more popular course of action. As Steven Schoenfeld outlines in his book, "Active Index Investing: Maximizing Portfolio Performance and Minimizing Risk through Global Index Strategies," there are four qualities inherent to successful investing: diversified asset allocation, risk budgeting of strategies, disciplined rebalancing and rigorous cost controls. ETFs lend themselves to each.