ETFs for Tomorrow

Investing in index funds can be all the Foolish strategy you need to build a financially rewarding portfolio. You get instant, low-cost diversification across a variety of industries, and you never have to worry about timing the market.

Making automatic contributions into an index fund gives an average investor all the benefits of dollar-cost averaging, making it easy to save regularly for the future. Warren Buffett once noted that his favorite time to sell is "never." In that respect, index funds let you invest just like the Oracle of Omaha does.

That could explain why exchange-traded funds are now so popular. According to the Investment Company Institute, ETF assets totaled more than $507 billion of the more than $1 trillion in stock index funds as of August.

A basket of stocks
ETFs, originally modeled after index funds, are mutual funds that trade like stocks. The first batch of ETFs, known as SPDRs ("spiders"), offered even lower expense ratios than many index funds, along with some additional tax efficiency. The ability to trade ETFs like stocks added to their popularity, although Fools should note that increased taxes and trading costs can erase any benefits from buying and holding an ETF.

As ETFs proliferated, they gradually narrowed their contents, from broad indexes to specialized slices of the market. That's been a boon to investors seeking to home in on certain areas of the market by buying a basket of related stocks. But it also concentrates the risk that accompanies such specialization, tilting a portfolio away from the diversification that makes index investing attractive.

Today, we're looking at the exchange-traded funds that exhibit the lowest turnover ratios. As the Fool's 60-Second Guide to ETFs explains, ETFs generally have lower turnover than mutual funds, and investors save on capital gains taxes as a result. According to the American Association of Individual Investors, stock mutual funds typically have a ratio around 80%, while bond funds are closer to 100%, meaning that the dollar value of fund purchases or sales equaled the dollar value of total fund assets during the year.

And ETFs aren't immune to turnover concerns: The iShares Lehman Aggregate Bond (AMEX:AGG) ETF, for example, has a turnover ratio of 483%, meaning it has turned over its portfolio almost five times over the past 12 months.

A diamond in the rough
All of these funds have a 0% turnover ratio, which can be partially explained by noting that four of the six funds started up less than a year ago. Yet it's not difficult to understand why the old-timer of the bunch -- the Diamonds Trust -- has such a low turnover. The ETF seeks to mimic the 30 companies that comprise the Dow Jones Industrial Average, and the guardians of the Dow are slow to move stocks in and out. The last change was made in 2004, when Verizon (NYSE:VZ), Pfizer (NYSE:PFE), and American International Group (NYSE:AIG) were added to the average. General Electric (NYSE:GE) has been a member since 1896.

An investment in the Diamonds comes down to a bet on the companies in the Dow. Earlier this summer, CAPS investor HistoricalPEGuy checked their P/E ratio (hence his screen name, presumably) and found them attractive:

When the entire Average starts to look cheap, buy the ETF - DIA. If you are like me and don't want to bail out of equities in the face of impending doom (damn you, Greenspan), the DJIA isn't a bad place to be, especially when its on the cheap and paying dividends while you wait for the market to recover. Speculative stocks will get trampled while blue chips will get a more minor correction, presenting itself with yet another great buying opportunity in a large handful of great companies.

A basket of opinions
Although ETFs have been around since the 1990s, investors might want to be cautious with any ETF that doesn't have a long track record. On CAPS, tell us whether you think these ETFs will continue to outperform, or whether it's time for new ones to ascend to the top of the lists.

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