Suddenly, everyone's talking about exchange-traded funds. Are they right for you?

IN TERMS OF net assets, Standard & Poor's Depositary Receipts (SPY), or Spiders, are by far the biggest ETFs. Launched in 1993 by State Street Global Advisors, they now boast more than $41 billion in assets (as of Apr. 2, 2004). Next come the Nasdaq-100 Index Tracking Stock (QQQQ), commonly referred to as Qubes, Barclays iShares S&P 500 (IVV) and iShares MSCI-EAFE (EFA), with assets of $23.6 billion, $8.6 billion and $7.6 billion, respectively.

Such broad-based index products are especially appealing to buy-and-hold investors. More-active traders might consider sector-based ETFs. Someone who thinks, say, energy is a good investment but isn't sure which stock to buy might consider an energy ETF. For those who want to add some real estate to their portfolios, a real estate investment trust ETF might be a prudent move. A health care professional with large holdings of health care stocks might buy a put option on a health care sector ETF to minimize risk. And on and on.

Down the road, Steven Schoenfeld, senior research fellow at Duke University's Global Capital Markets Center and founder and editor-in-chief of IndexUniverse.com, anticipates there will be a much broader selection of ETF offerings in the U.S. Products that track commodities and currencies aren't too far off, he says. Both Barclays and Equity Gold Trust (sponsored by the World Gold Council) have plans for gold ETFs in the works. And ETFs that track crude oil or nonferrous metals could start cropping up too, says Schoenfeld.

As ETF offerings blossom, investors will surely call on increasingly sophisticated strategies to exploit them. Hedge funds will likely be the pioneers. Right now, most of them use ETFs both to maximize gains and to minimize risk. A common tactic is to play a single stock off its industry group. Say a hedge-fund manager thinks Intel will outperform its peers. He'd buy Intel (INTC) and short-sell an ETF that tracks the chip sector — say, iShares Goldman Sachs Semiconductor Index (IGW). The same sort of long/short strategy can be executed with put and call options as well. And that's just the beginning.

In the fixed-income arena, the benefits of ETFs are even clearer. The performance difference between similar bonds typically isn't all that large; usually, it comes down to transaction fees. Buying a single fixed-income ETF is more cost-efficient — and is far easier — than laddering different notes of varying maturities, says David Haywood, director of alternative products research at Financial Research Corp.

Where the Money Is
Name Symbol Net Assets
S&P 500 SPDR SPY $41,310,216,440
Nasdaq-100 Index Tracking Stock QQQQ 23,559,292,000
iShares S&P 500 IVV 8,609,648,000
iShares MSCI-EAFE EFA 7,608,966,000
DJIA Diamonds DIA 7,314,650,550
S&P 400 MidCap SPDR MDY 6,575,515,560
iShares Russell 2000 IWM 5,398,776,000
iShares MSCI-Japan EWJ 4,708,884,000
Vanguard Total Market VIPERs VTI 3,020,731,560
iShares Russell 1000 Value IWD 2,731,590,000
Data as of April 2, 2004
Source: The American Stock Exchange

Some asset managers, such as San Francisco-based Main Management, rely solely on ETFs to construct client portfolios. With $120 million under management, Main targets wealthy customers, requiring a minimum investment of $1 million. Its strategy is simple: Invest in attractively valued, underperforming sectors with good prospects, in the most cost-effective way possible. The firm's bellwether portfolio owns anywhere from 12 to 18 ETFs, consisting of about 1,900 stocks. As Jane Husband, a partner at Main, puts it, the firm is "going after the haystacks, instead of the needles in the haystacks."