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ETF Tip No. 1: Don't Believe the Hype

At the close of November 2004, the exchange-traded fund industry's coffers were positively brimming with assets. The Investment Company Institute -- the fund industry's research and lobbying arm -- reported a grand total of more than $211 billion in ETFs at that point, an increase of more than 40% since the end of 2003.

Given that precipitous trend line, now seems like an excellent time to review the good news -- and the bad -- about ETFs. Let's start with the good.

For index investors with a chunk of change to plunk down all at once, exchange-traded funds (ETFs) can offer a convenient alternative to plain-vanilla index funds. For starters, these puppies generally run with expense ratios significantly lower than those of rival mutual funds.

The popular SPDR (AMEX: SPY  ) ETF, for instance, will ding you just 0.10% a year, while Vanguard 500 (FUND: VFINX  ) costs a comparatively whopping 0.18%. And since both funds track the S&P 500 -- and therefore invest in such stalwarts as Microsoft (Nasdaq: MSFT  ) , General Electric (NYSE: GE  ) , Citigroup (NYSE: C  ) , Johnson & Johnson (NYSE: JNJ  ) , and Wal-Mart (NYSE: WMT  ) -- investing in the cheaper fund seems like a no-brainer, right?

Not necessarily.

For folks who invest relatively small amounts at regular intervals (i.e., dollar-cost averaging), ETFs make little sense. Because they trade throughout the day like stocks, you have to pony up a brokerage fee each time you trade an ETF. And as you'd expect, those transaction costs can quickly erode any expense-ratio advantage an ETF might have over a traditional mutual fund.

The bottom line: When it comes to investing in ETFs, don't be lured by a seemingly cheap price tag alone.

Next up: ETFs -- Buyer Beware

This article was originally published on Jan. 6, 2005.

Shannon Zimmerman writes regularly about index funds and ETFs in hisChampion Fundsnewsletter service, which you can try free for 30 days. Shannon owns no securities mentioned.

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