Why Exchange-Traded Funds Make Sense

ETFs: A Role in Any Investment Program

Many of the huge institutional investment portfolios, such as college endowments and state retirement plans, make generous use of ETFs.

If you really don't want to pay any attention to your investments, ETFs will assure that none of your investments will do any worse than the market as a whole. Simply slot these passive investments into your diversification framework and periodically rebalance your investments. Active investors can also benefit from ETFs by using them to build asound foundation to a diversified investment portfolio.

More Is Not Necessarily Better

In addition to the better-known U.S. and foreign indexes described above, ETFs are available in specialized areas, including industrial sectors such as energy, health care, real estate, and single-country or single-region foreign funds. But more choices are not necessarily a good thing. Here are two red flags:

1. Index-tweaking ETFs: In order to distinguish themselves from the old-fashioned ETFs that we've come to love, many recently introduced ETFs more actively manage the fund holdings in order to try to beat the underlying index. But others have employed this strategy with different types of investments, with dismal results. As with anything else you invest in, it's usually best to stick with what you understand. If you want a passive investment vehicle, get a regular ETF. If you want active management, get a mutual fund with a great track record.

2. ETFs in hot sectors: Wall Street isn't naive. The investment companies like to give investors what they want. So whenever a particular market sector has shown explosive growth, Voila! New ETFs representing that sector are introduced. Before committing to one of the new ones, consider the distinct possibility that you might begetting into that sector a wee bit late. On the other hand, if you want to place a sector bet—for example, you think health care stocks are going to perform very well—a sector ETF can be an excellent and low-cost way to play a sector.

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