Get Off the Sidelines and Into ETFs

Let's suppose you're one of those investors who has been watching and waiting and thinking about how and when to get into the stock market, but it never seems like the right time. For you there is good news and bad news.

The bad news is that you're never going to wake up one morning and hear a voice that says: "Today is the day. Tomorrow the market begins its climb."

I have a friend who always asks me, "What should I buy now?" I'll give her an answer, and then, when I see her two or three months later, she says: "Mary, that investment you recommended went up, and then I thought it was too expensive. Then it went down, and I thought maybe it wasn't as good as you thought it was. So I just couldn't decide what to do."

Don't Be Afraid

This friend will probably never become an investor. The do-nothing hurdle is one you must get over yourself.

The good news is that the exchange-traded funds, or ETFs, provide a solid entry point. Professional investors such as those at pension funds and other institutions use exchange-traded funds because they provide a pure asset class at low cost with good tax efficiency. And there is no portfolio manager to monitor.

Planners tell me they use them rather than mutual funds because of their flexibility. They can put stop-loss orders on ETFs to limit losses, and they can sell them short to hedge exposure to stocks. Selling short means you borrow a security, sell it and then hope to buy it back later at a lower price to repay the loan. You keep the difference between the original sell price and the lower buy price.

The only negative is that you must pay a one-time commission. So you must weigh the tradeoff. As I wrote in a column on Oct. 24, TIAA-CREF offers basic index mutual funds at low cost with a minimum investment of just $50 a month. For beginners with a small amount of money to start, these funds are excellent. There's no commission, but you pay a small annual expense fee for as long as you own the fund.

Your choices are more limited with TIAA-CREF, which offers just nine index funds. Investors who want a broader choice of indexes, particularly those who want funds in individual industry sectors or foreign countries, should take a look at the exchange-traded funds.

Index funds work best for broad market exposure, for asset-class management and for investing in specific industry sectors. They are less attractive for style-based investing, by which I mean funds that use the value or growth approach to investing. ETFs offer many style-based options, including value and growth indexes in all shapes and sizes managed by the Frank Russell Co. and Standard & Poor's.

A stock picker comes in handy in choosing value stocks. But you might be interested to see that the iShares S&P MidCap 400/Barra Value Index, which is offered as an ETF, blew away two of the mid-cap value funds I own, Dodge & Cox Stock and Longleaf Partners, in the 16 months the mid-cap ETFs have been available.

To get started in ETFs, assuming you have no other investments, I would buy a very broad market index such as the Vanguard Vipers, which follows the Wilshire 5000. This fund is the ETF version of the Vanguard Total Stock Market Index, but with an even lower expense ratio, 15 basis points for the Vipers versus 20 basis points for the mutual fund.

The Vipers Appeal

Another choice is the iShares Russell 3000, which follows the 3,000 largest stocks traded. I like this index as a measure of the market more than I like it as an investment. The index represents the 3,000 largest stocks as of June 30 and so it is reconstituted each year, which makes it less tax-efficient than the Vipers. It also makes it, to my mind, less appealing.

For instance, last June, the technology allocation in the Russell 3000 grew, because technology companies had grown larger in the previous year. That served investors in the index poorly as it piled more money into recent winners, and those winners took a terrible hit the remainder of the year.

So I'd start with the Vipers. And then I'd be looking for something that performs against the Vipers, something that does well when the market does poorly. Using the charting tool on MSN, I tried all kinds of ETF indexes here, like the Dow Jones Energy Sector and the Basic Materials Sector and the Technology Sector.

What you'll see if you call up the charts on these sectors is that both energy and basic materials have been outperformers this year and technology an underperformer. But all the sectors move in sync with the overall market. So when one goes up the others go up, even though they may be way above or way below the overall market.

The Real Estate Factor

I did find one sector, though, that didn't show this positive correlation -- real estate. There are three real estate ETFs: the iShares Trust Dow Jones U.S. Real Estate Index, the iShares Cohen & Steers Realty Majors Index Fund, introduced in February, and the StreetTracks Wilshire REIT Index Fund, introduced in August.

If you had started at the beginning of the year with the Dow Jones index, you'd have a gain of about 4% versus a decline of 14% in the S&P 500.

Those two funds could make a nice portfolio core, say 75% in the Vipers and the other 25% in a real estate fund. The adventuresome could add some industry sectors.

At the time of publication, Mary Rowland owned shares in the following equities mentioned in this column: Dodge & Cox Stock and Longleaf Partners Fund.

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