The Essential Guide to ETFs

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

WHERE WERE YOU when the mutual fund scandals broke?

The laundry list of complaints rattled off by New York Attorney General Eliot Spitzer last September was startling. From big-moneyed customers making illegal trades to jacked-up fees for the little guy, one sordid revelation after another buffeted an industry thought to be above reproach.

Unsettling though the scandals may be, they're just the latest reason that some investors have looked beyond regular old mutual funds in recent years.

Critics point out that few actively managed portfolios outperform the broad market over the long run. Indeed, through Feb. 2004 only 305 of 1,124 domestic equity mutual funds -- or 27% -- had topped the Standard & Poor's 500's 10-year annualized return of 11.35%, according to Morningstar. And just 144 -- or 13% -- have beaten the Dow Jones Industrial Average's 10-year annualized return of 12.94%. That's enough to make anyone think twice about paying high fees or pricey sales loads for a fund manager's supposed expertise.

Those two issues -- performance and fees -- have been the rationale behind index investing for years. Throw in allegations of malfeasance at a few prominent fund firms, and it's no wonder investors have grown restless for alternatives.

Some, sick of high fees or shabby treatment from the likes of Strong Investments and Putnam Investments, are paring down their holdings, keeping a core group of actively managed funds run by firms that aren't ripping them off. Thankfully, there are still plenty to choose from. Major fund firms not implicated in the scandals include Vanguard, Fidelity, American Funds and T. Rowe Price.

Some investors, however, are running straight into the arms of exchange-traded funds -- portfolios of stocks or bonds that offer greater transparency, lower fees and more tax efficiency than mutual funds. There are ETFs that track major and minor stock indexes, individual sectors and even bond indexes. Like conventional index investments, ETFs allow investors to be as active or passive as they wish. Entire portfolios can be built using plain-vanilla index ETFs that offer broad exposure to stocks and bonds. More-sophisticated investors might instead choose to cobble together portfolios based on a dozen or more sector ETFs.

One important distinction: Unlike traditional index funds, ETFs can be bought and sold throughout the trading day at intraday prices, rather than based on a fund's net asset value at 4 p.m. (Eastern time) on any given day. This might not matter much to long-term investors who evaluate their portfolios over periods of years rather than hours -- but it can be a big advantage for traders.

Think of ETFs as mutual funds that can be bought and sold just like stocks.

"To me, ETFs are an evolutionary advance, bringing institutional-quality products to all investors," says Steven Schoenfeld, senior research fellow at Duke University's Global Capital Markets Center and founder and editor-in-chief of IndexUniverse.com.