Bottom-Feeding With ETFs

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Exchange-traded funds have exploded in popularity in recent years. With the market down, however, investing in beaten-down ETFs -- those funds trading well below their peak prices or that no longer reflect the trend of the day -- can be a profitable exercise. To increase the odds of success, you can invest in a widely diversified fund or narrow the options to a few sectors. Whatever approach you take, the best time to start looking is when prices have been reduced.

Take advantage of opportunity
Unfortunately, you can never be sure when the perfect market entry or exit points are. But it's a fact that over time, stocks have beaten cash and bonds in the past. Sinking home prices and geopolitical risks lurking throughout the world make hibernating to the safety of cash look attractive. However, bears that awaken late to rising markets often have only leftovers to feed on. Getting back into the markets before they rise is usually more profitable than sitting on the sideline waiting for a precise entry point that may never come.

It's difficult to discern where the economy is headed. The markets are of only limited use in guiding us. Although the stock market is forward-looking, its mood swings make it clear that it doesn't always focus on the long-term. In an uncertain environment, if you are a long-term investor and have exposure to the market, then you can endure the ups and downs more easily.

Broad market selections
With the market down from recent highs, stock prices are lower than they were. Whether or not they will drop further is hard to say, but if you want exposure to the broad market, an ETF is one of the easiest and most inexpensive approaches. A 10%-15% discount on the market is a good opportunity to pick up a broad market fund like the Vanguard Total Stock Market ETF (AMEX: VTI).

Picking through sectors
Sifting through market sectors that have fallen far and fast can often yield ideas for potential investment opportunities. Of course, there is no guarantee these sectors will come out of their slumps anytime soon, so patience is an important trait for investors taking this approach. In 2007, the subprime and real estate mess hammered real estate, construction, and finance. Fears of a weaker economy and consumer spending have also put the retail sector and small-cap stocks on sale.

The pain in the real estate and construction sectors has been going on for several years, and prices for some stocks in these sectors are off 50% or more. Two real estate-related funds to consider are the iShares Dow Jones U.S. Home Construction ETF (NYSE: ITB), which tracks the Dow Jones U.S. Home Construction Index, and the SPDR S&P Homebuilders ETF (AMEX: XHB), which tracks the performance of the S&P Homebuilders Select Industry index.

Retail has been knocked down, as a slowdown in consumer demand seemed imminent amid the crisis in credit and housing. This is another sector that may turn around if efforts to prime the economy are successful. The PowerShares Dynamic Retail ETF (AMEX: PMR) has a heavy concentration of retail stocks in its portfolio.

Think small
Small-cap stocks have also come off a long run of positive returns with a major correction, and that has cut prices on ETF shares. The Rydex S&P SmallCap 600 Pure Value ETF (AMEX: RZV) gives investors exposure to small, dynamic companies. During recessions, small companies often have more difficulties than their larger counterparts, since they don't have as diversified a revenue base. But when the economy turns around, these companies are nimble enough to take advantage of and profit from the good times.

While bears sleep or hide in their cave, the market often turns in surprisingly good returns. Being a contrarian and looking at beaten-up parts of the market often pays off better than going with the crowd.

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