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Judge an ETF by Its Fundamentals

When the world's first exchange-traded fund, the S&P 500 SPDR (SPY), was listed over a decade ago, things were simpler. People were broadly familiar with the underlying index, and, assuming an investor already wanted to track it, explaining the advantages and disadvantages of the ETF structure versus that of a comparable index mutual fund was the only analysis necessary.

Since then, however, the number of ETFs available to investors has exploded. The array of over 400 choices and the flexibility it brings is positive, but having so many choices also complicates the selection process. How do I know which ETFs make the most sense for my portfolio?

Perhaps because ETFs have always been compared with mutual funds, analysts have started to evaluate them as if they were mutual funds. Morningstar, for example, the large mutual fund rating outfit, says in materials on its Web site, "The Morningstar Rating for exchange-traded funds uses the same methodology as the Morningstar Rating for [mutual] funds."

Therein lies the problem. Mutual funds are typically evaluated based on past performance and fees. That's appropriate for most of these products, which are actively managed, because what you are really doing is hiring a manager to invest on your behalf. But with ETFs, it's different. There is no active manager deciding when to buy or sell certain stocks -- no one, for example, deciding when to lighten up on a certain sector or when to increase exposure to a certain market cap segment.

There is nothing inherently good or bad about a particular index that an ETF tracks. Rather, the investment merit of an ETF is determined by two factors: market conditions and the fundamentals of the underlying stocks that comprise the fund. These, of course, change all the time.

This difference is like night and day: One is backward-looking, and one is forward-looking. Who is not aware that, over the past five years, technology stocks in general were a bad investment? What moderately informed investor doesn't already know that, over the same time period, small-cap stocks outpaced large-cap stocks?

If a mutual-fund manager failed to foresee changes in the economy and in the market and stayed overexposed to large-cap tech stocks, you'd have a valid complaint that he was probably not earning his keep. But the reason an ETF tracking an index of tech stocks, or an index of large-cap stocks, didn't change its portfolio is that it isn't supposed to -- it is just supposed to track the index.
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