Buy the Basket

By Daniel Kadlec

Investors have been net sellers of stock mutual funds most of the summer. Yet in this abysmal market their love affair with exchange-traded funds, or ETFs, has truly bloomed. In June and July combined, stock funds saw estimated outflows of $60 billion, while ETFs had inflows of $11 billion. What gives them such allure? All the things that suddenly matter when markets turn rocky: diversification, tax efficiency, low costs and portfolio visibility that would make most fund managers blush.

ETFs are stock funds that trade on an exchange like common shares of IBM or Coca-Cola. The first ones were launched in 1993. Amid heavy marketing by key players, including Barclays Global Investors and Merrill Lynch, asset growth has taken off in recent years, swelling nearly ninefold since 1998 to $88 billion in the U.S. etf inflows this year have already doubled the total from all of last year. ETFs have proved so popular that Barclays extended its line in July to include bonds, the first ETFs of that type. It's now possible to build a well-diversified global portfolio using nothing but ETFs.

Here's how they work: an etf share represents a basket of stocks or bonds typically pegged to a major index such as the S&P 500 or Morgan Stanley Capital International's benchmark foreign index, eafe (Europe, Asia, Far East). There are now 102 such ETFs in the U.S., including some that target specific industries and countries. They can be bought and sold through any broker and can be traded through the day.

ETFs have distinct advantages over open-end stock funds. They tend to be widely diversified, and investors can get a daily view of what's in the fund. The annual management fee is low, and ETFs are tax efficient because the stocks within them seldom change and their unusual structure ensures that holders rarely if ever get socked with a capital-gains distribution. You can even sell an etf short (bet on the price to fall). There are disadvantages, like trading commissions that can quickly erode the benefits of ETFs, which for that reason make no sense for investors who sock money away on a monthly basis. ETFs are ideal for those who have a lump sum and want to spread it around the globe, as well as for those who want to speculate on near-term market moves or hedge other holdings in times of uncertainty. Institutions have embraced them, driving down the cost structure; they may be suitable for you too.

Say you have a long-held bond with a big gain. You suspect that rates are going to move up for a while and push bond prices down. Rather than sell your bond and pay tax, you can sell short the iShares Lehman 7-10 Year Treasury (ticker: IEF) to hedge against a rate decline without triggering a tax bill.

With so many ETFs available, investors can tailor a global portfolio to their needs, emphasizing growth or value, keeping some bonds for stability and adding regions that seem most appealing. Today a growth investor would do well with iShares Trust Russell 3000 Growth (IWZ). Analysts are upgrading earnings estimates for companies in that index faster than in other large growth indexes, Merrill Lynch reports. A value investor would do well with iShares S&P/ Barra Value (IVE). Companies in that index have the lowest price relative to book value of competing large-value indexes, Merrill says. Those holdings could be rounded out with specific industries that have promise, like real estate (iShares Cohen & Steers Realty Majors: ICF) and utilities (Utilities Select Sector SPDR: XLU).

There are 22 ETFs pegged to Morgan Stanley single-country indexes. A good one-shot foreign portfolio is iShares MSCI EAFE (EFA). But you could add, say, iShares MSCI South Korea (EWY), getting more exposure to a country in which many pros are overweight. Even in a bad market there are winners, and ETFs make it easy to scour the globe for them.