The Magical Land of ETFs

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In the movie The Wizard of Oz, Dorothy finds herself magically transported to the colorful land of Oz, filled with strange creatures such as talking lions, diminutive townspeople, and flying monkeys. They sure didn't have anything like that in Kansas!

For investors who first venture into the land of exchange-traded funds, it can sometimes feel the same way -- as if you're in another world. All of the strange names and jargon can be a little confusing at times. Fortunately, I see a yellow brick road right ahead to guide us through this strange Land of ETFs.

We're not in Kansas anymore
ETFs are basically mutual funds that trade like a share of stock. An ETF represents a basket of stocks in one of a wide range of investment areas, though the original ones tended to represent one of the more common indices, such as the S&P 500 or the Dow Jones Industrial Average. But whereas mutual funds are valued and traded once a day, at the market close, ETFs can be traded throughout the day and even bought on margin and sold short. So ETFs essentially combine the diversification of a mutual fund with the trading flexibility of a stock. This is no doubt a big part of the reason ETFs have become increasingly popular in recent years.

The inhabitants
If you're new to the Land of ETFs and want to see what the countryside has to offer, a sensible place to start is with some of the more common and most popular ETFs. These funds track broad equity indices and typically offer investors the greatest diversification bang for their buck.

  • Spiders (AMEX: SPY  ) : SPDRS, or Standard & Poor's Depository Receipts, were the first ETF ever created, way back in 1993. Spiders track the S&P 500 Index and are an excellent stop for new travelers in ETF Land. Buying a Spider is basically like buying a share of the Vanguard 500 Index mutual fund (VFINX), except you get the added trading flexibility. As far as lower risk and diversification go, you can't do much better than a Spider.
  • Diamonds (DIA): Diamonds represent ownership in the Diamonds Trust series, which tracks the stocks held in the Dow Jones Industrial Average. This well-known index tracks the performance of 30 of the biggest and most widely held companies in the United States, including Wal-Mart (NYSE: WMT  ) , Procter & Gamble (NYSE: PG  ) , and Merck (NYSE: MRK  ) . It represents a much more limited view of the market, but if you have a place in your portfolio for exposure to large-cap blue-chip stocks, a Diamond can be a girl's (or even a guy's!) best friend.
  • Cubes (QQQQ): Cubes (or Qubes) are the name given to PowerShares QQQ, which tracks the Nasdaq 100 Index. This index contains the 100 largest non-financial companies listed on the Nasdaq stock market and is currently led by Apple (Nasdaq: AAPL  ) , Qualcomm (Nasdaq: QCOM  ) , and Microsoft (Nasdaq: MSFT  ) . While Cubes give you a decent amount of diversification, investors should be aware that they will be heavily weighted in the technology sector. But if you have other funds or ETFs that provide you with exposure to other sectors of the market, a Cube might be a welcome addition to your fledgling ETF portfolio.

The poppy fields
However, as anyone who spends any meaningful amount of time in the Land of ETFs soon finds out, the variety of funds available to investors has grown far beyond those plain-vanilla funds that track popular indices. There are now funds available that track specific sectors, industries, and countries, so that investors can now maintain a maddeningly narrow focus on the market. Think of these funds as the Poppy Fields in the Land of Oz. Don't be lured in by their pretty colors and flashy outsides -- you don't need them. I can't think of many investors who need to have an entire ETF in their portfolio focused on Brazilian small-cap companies or domestic solar energy stocks, for example. Don't give in to the hype, and avoid these types of narrowly-focused funds.

While the Land of ETFs may seem strange at first glance, once you understand what ETFs really are and break the code behind several of the most popular ones, the countryside is not quite so foreign as it once seemed. Just be sure you stay on the yellow brick road and stick to broad index ETFs that provide adequate levels of diversification at a low cost. Stay away from the narrow, specialized funds, and your journey will likely be a successful one. Now all you need to do is watch out for the flying monkeys.

For more on using ETFs in your portfolio, read about:

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This article was originally published on May 2, 2007. It has been updated by Dan Caplinger, who owns shares of Spiders and Cubes but none of the companies mentioned in this article. Wal-Mart and Microsoft are Motley Fool Inside Value picks. Apple is a Motley Fool Stock Advisor recommendation. Try any of our Foolish newsletters today, free for 30 days. The Fool's disclosure policy will get you, my pretty, and your little dog, too.

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