Best ETFs for This Market

Exchange-Traded Funds (ETFs) are growing as fast as crabgrass in August. And most ETFs should be treated like weeds. ProShares UltraShort Financials, for instance, aims to return double the inverse of a financial-stock index on a daily basis. Buying lottery tickets is a surer path to profits.

But a handful of simple, broad-based ETFs offer terrific opportunities for investors. If you use a brokerage account, you probably should consider them. They’re usually even lower-cost than traditional index funds.

First things first: What are ETFs? As the name implies, they’re mutual funds that trade on the stock exchanges just like ordinary stocks. Almost all ETFs track indexes, such as Standard & Poor’s 500-stock index. Unfortunately, many follow very narrow indexes. Bullish on cotton? You can buy iPath DJ UBS Cotton.

But you can build a first-class, low-cost portfolio with the good ones. In picking ETFs, start with Vanguard, the low-cost leader in funds. Ishares also offers broad, reasonably priced ETFs.

Are ETFs for you? As with buying and selling ordinary stocks, you pay a commission every time you trade an ETF. At most of the big online brokerage firms—such as Fidelity, Schwab and TDAmeritrade—commissions are only about $10 a trade. But if you’re investing a little bit every month, even $10 commissions mount up. Vanguard offers low-cost index funds for only a little more than ETFs. ETFs make more sense than regular funds for investors making relatively large and infrequent purchases. Here the low annual expense ratios trump the brokerage commissions.

How to divvy up your money in ETFs

Here’s how I’d allocate my money among ETFs in today’s market. If you’re in the 28% federal tax bracket or higher, put your bond money into ishares S&P National Municipal Bond ETF (telephone 800-474-2737, symbol MUB), which charges 0.25% annually to track a broad, tax-free bond index. In this instance, a regular mutual fund might actually be a better option, Vanguard Intermediate-Term Tax Exempt (800-635-1511, VWITX) charges just 0.20% annually and is less sensitive to changes in interest rates.

Investors in a lower tax bracket or who are investing in bonds in a tax-deferred account should choose Vanguard Total Bond Market index ETF (BND). It charges 0.14% annually and reflects Barclays U.S. Aggregate taxable bond index.

Start by putting 50% of your stock money in Vanguard Total Stock Market ETF (VTI). Its expense ratio is a mere 0.07%. It tracks the MSCI U.S. Broad Market Index, which covers essentially the entire U.S. stock market. Larger companies predominate, as they do in most broad-based stock market indexes.

Stocks of large companies are cheap relative to small companies. Small-company stocks currently trade at higher price-earnings ratios than large-company stocks. That's unlikely to continue. Usually, large companies command higher price-earnings multiples than small companies. Large companies also offer relative safety in uncertain markets.

Next invest 20% in Vanguard Mega Cap 300 Growth ETF (MGK). This ETF owns the nation’s largest growth stocks. Almost 30% of assets are in fast-growing technology stocks, yet the average P/E of the stocks in the fund is a thrifty 13 based on earnings over the past 12 months. Its expense ratio is 0.13%.

When large-company stocks do well, mega caps (the largest of the large) often do the best of all. What's more, growth stocks, like large-company stocks, have been out of favor ever since the tech bubble collapsed in 2000-2002.

Put 20% in Vanguard FTSE All-World ex-U.S. ETF (VEU). Don't worry about the big mouthful of a name. This ETF gives you the world's stock markets—except the U.S. Its expense ratio is 0.25%.

To raise your stake in fast-growing emerging markets, invest 10% in Vanguard Emerging Markets ETF (VWO), which has an expense ratio of 0.25%. The future lies with emerging markets; you don't want to shortchange them.

This is hardly a buy-and-forget portfolio. Over the long haul, small-company stocks and so-called undervalued stocks have tended to beat large-company stocks and growth stocks. So some adjustments will inevitably be necessary, although perhaps not for a couple of years.

August 12, 2009

—Steven T. Goldberg