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Invest Like the Big Boys
Exchange-traded funds are moving from Wall Street to Main Street

Every month, it seems, Wall Street comes up with some newfangled investment idea. The array of financial products is now so dizzying that the old lumpy mattress is starting to look like a more comfortable place to stash the cash. But there is one new product out there definitely worth looking at. Something of a cross between an index mutual fund and a stock, it's called an exchange-traded fund, or ETF.

Just as computers, fax machines and Humvees were used by big institutions before they caught on with individual consumers, so it was with ETFs. They were, in fact, developed for such institutional traders as investment banks, hedge funds and insurance firms because, among other things, they allow for the quick juggling of massive holdings. Big traders like that sort of thing. Personally, playing hot potato with my money is not my idea of fun. But all the same, over the past two years, I've invested most of my own savings in ETFs.

I'm not alone. "ETFs have grown exponentially in the past few years—47 percent in 2004—and they will surely continue to grow and gain influence," says Dan Culloton, a financial analyst with the investment research firm Morningstar. While I can't claim that my purchase of ETFs accounts for much of the growing $220 billion ETF market, I'm happy to be a (very) small part of it. Here's why:

ETFs allow you to diversify intelligently. Most financial experts agree that playing with individual stocks can be hazardous to one's wealth. Anything from an accounting scandal to the CEO's sudden angina attack can suddenly send a single stock spiraling downward. That's why it makes sense for the average investor to own lots of stocks-or bonds-through ETFs or mutual funds.

Although there are many more mutual funds than ETFs (roughly 6,300 TO 152), ETFs tend to represent entire indexes, that is, very large slices of the market like U. S. small stocks. And, says Cullton, years of observation tell us that those who invest in index funds tend to do far better than the average investor who picks his own stocks. You could still invest in traditional index mutual funds, of course. They, too, are excellent choices. However, because of complicated technical differences, ETFs may have another advantage.

ETFs are cheap. Many carry total management expenses under 0.20 percent a year. Some of the larger ETFs carry management fees as low as 0.09 percent a year. In addition, ETFs are very tax-smart, much more so than most mutual funds, says Ken Weingarten, a fee-only financial planner in Lawrenceville, New Jersey. Because of the clever way ETFs are structured, he explains, the taxes you pay on any growth will be minimal. "The low fees and the tax efficiency are both huge benefits."

But there is a catch. "Using ETFs is an excellent way to implement a low-cost, low-maintenance, tax smart, well-balanced portfolio—but it won't work for investors who make regular small deposits or withdrawals," says John Carrig, an independent investment adviser in Deerfield Beach, Florida. Because ETFs trade just like stocks, you'll pay a commission each time you buy or sell. Depending on the brokerage house, that might be anywhere from $5 and up per purchase. So unless you're looking to invest a lump sum of at least $2000 or so, and leave it untouched for at least a couple of years, it may be cheaper to got with an index mutual fund.

"ETFs are generally best for taxable accounts where the deposits and withdrawals are few and far between," says Carrig. "They make excellent building blocks that allow even the smallest investor to create a professional caliber portfolio." He suggests that a solid portfolio of ETFs might begin with a foundation of large value stocks, large growth stocks, small stocks, international stocks, short-term bonds and longer-term bonds. The specific allocations should vary depending on your personal situation.

Any brokerage house that trades in stocks and bonds will also trade ETFs. Remember that an ETF can be risky or safe, depending on the index it matches. Some ETFs, for example, track small stocks, and you would expect much greater volatility (and greater long-term returns) than you would, for example, with an ETF that tracks short-term U.S. Treasury bonds. If you're going to build an entire portfolio of ETFs, you'll want to include various kinds.

That's what the big boys do.