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Can't Use Rearview Mirror on ETFs

This column was originally published on RealMoney on Sept. 28 at 4:00 p.m. EDT. It's being republished as a bonus for readers.

Exchange-traded funds are different from typical index funds and much different from actively managed open-end funds. ETFs are index funds that trade throughout the day like a stock, while OEFs price once a day after the stock market closes. One more important difference: ETFs are very new, which means that many do-it-yourselfers do not know much about them and many investment professionals and market-related Web sites still are learning how to analyze them properly.

While I may or may not know the best way to analyze ETFs, I sure do know a bad way to analyze them: to look at ETFs as if they were OEFs. An investor who wants to buy an actively managed OEF may find that there's not much to analyze, because that investor is really buying the manager's past performance on faith that that past performance can be maintained. Some bets, like Bill Miller, are better than others. Obviously, there's more to fund selection than this, but ultimately, it comes down to a belief in the manager.

Analyze This Differently

Faith in a manager plays no role in picking an exchange-traded fund. In most cases, ETF selection boils down to forward-looking analysis of a given sector, country, style, capitalization size and so on. ETF selection also involves selecting the best product to capture a given effect.

For example, on the basis of a forward-looking analysis of supply and demand, economic conditions or technical analysis, an investor could decide to overweight or underweight the tech sector and buy the appropriate amount of a tech ETF to capture what that investor believes will produce the desired effect. After deciding that being overweight tech makes sense right now, an investor might then analyze the various tech ETFs available and decide that the Technology Sector SPDR (XLK) is the best choice to trade. This could be applied to both long-term investors and short-term traders.

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