Andrew Leckey

More than $1 trillion is currently invested worldwide in exchange-traded funds and those assets continue to grow as new ETFs are introduced and investors discover the concept.

International ETFs are especially hot in 2010, while those focused on specific industries such as utilities, banking and technology are also gaining assets.

By holding baskets of stocks, bonds or commodities, ETFs replicate indexes or sectors with a goal of low-cost diversification. ETFs are traded on an exchange so you can buy and sell during market hours, unlike a mutual fund in which you trade shares at the end of the day.

"I use ETFs mainly for targeted niche exposure because it is a good way to get at areas where a good mutual fund doesn't exist," explained Mark Salzinger, editor of The Investor's ETF Report in Brentwood, Tenn. "In all my client accounts I have both mutual funds and ETFs because I think a combination of the two is optimal."

His international ETF focus is on Chile and Brazil, neither available in its own mutual fund. The iShares MSCI Chile ETF (ECH) is attractive because that country's copper exports are in high demand from China and India as they build infrastructure, he said. Though riskier, the small-cap Market Vectors Brazil Small-Cap ETF (BRF) lets an investor get deep into that burgeoning market, he said.

For those bullish on the U.S. economy, technology offers potential because tech companies have lots of cash, little debt and good product cycles, said Salzinger, who likes Vanguard Information Technology ETF (VGT) in that industry.

While you must pay to trade ETFs, their annual fees are generally lower than even index mutual funds.

"There are also tax advantages with ETFs for non-tax-deferred accounts since they're treated like a stock and you don't have any tax issue until you sell them--unlike a mutual fund," said John Mauldin, president of the Dallas-based Millennium Wave Investments advisory firm.

Despite that advantage, ETFs shouldn't be considered a "silver bullet" to win big in the current market, Mauldin cautioned. He recommends gradual investment in them rather than tossing a large chunk of money in a specialized niche.

Biotechnology ETFs are high on Mauldin's list because of strong potential over the coming decade for new discoveries to drive that market. Health Care Select Sector SPDR (XLV) and iShares Nasdaq Biotechnology Index Fund (IBB) are the ETFs he recommends.

High-dividend payers such as Utilities Select Sector SPDR (XLU) and iShares S&P Global Utilities Index Fund (JXI) also merit consideration, he added. Investors currently aren't receiving much in the way of returns and ETFs such as these would also cushion the blow of a bear market, he reasons.

"From a trading perspective, ETFs have the diversification and liquidity that you don't have with individual stocks, while from an investing perspective you have both liquidity and greater tax efficiency," said Scott Burns, director of ETF Analysis for Morningstar Inc. in Chicago. "We like to say ETFs brought about the democratization of investing, since they opened up areas to invest previously only for large pension funds and endowments."

He's a fan of regional banking ETFs. That group has lagged the overall financial sector and an expected period of increased commercial mortgage defaults should provide a buying opportunity when their stocks decline further. SPDR KBW Regional Banking ETF (KRE) is his choice.

Health care, especially medical devices, gains Burns' attention, as well. Even if the government changes the healthcare system, companies such as those included in the iShares Dow Jones U.S. Medical Devices (IHI) ETF feature necessities such as artificial hips and knee replacements that people won't skimp on. It is a high-margin business and the regulation risk that's been factored into the industry's stock prices is far beyond anything that could actually occur, he reckons.

Burns is not as high on corporate bonds as he once was and doesn't like Treasuries at all right now. Investors buying iShares Barclays Aggregate Bond Fund ETF (AGG) should understand fully that about 80 percent of the fund is in Treasuries right now, he cautioned.

The dilemma between choosing ETFs or mutual funds won't go away. It's important to know in what ways ETFs are a different animal.

"With ETFs there are transaction costs (through a broker to buy and sell), so if you're putting in $200 a month the transaction costs will be chewing up your returns in a hurry," warned Burns. "There's also a misconception that ETFs eliminate risk, which isn't true, because while it is less risky to own 300 stocks instead of three stocks, there still is some risk involved."

On the other hand, the average cost of an ETF is 55 basis points, which compares to an average cost of 82 basis points for an index mutual fund and 125 basis points for an actively-managed mutual fund, Burns added.

"The vast majority of ETFs are index funds, you can buy an ETF from any discount brokerage for $10 to $15 and they have no investment minimums like mutual funds," Salzinger said in summing up the differences. "Remember, you can buy or sell at any time during the day and, unlike a mutual fund, you're not captive to the closing price on the day of the trade."








Investing - Exchange Traded Funds Offer Low-Cost Diversification