Exchange-Traded Funds Under the Microscope

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The many advantages of index funds have made them one of the most important innovations in finance. Their combination of simplicity, low expenses, and tax efficiency give investors the chance to get everything they need from a single fund.

With the revolution in exchange-traded funds over the past several years, however, a huge number of new index strategies have emerged. Although actively managed ETFs are likely right around the corner, the ETFs currently available all have underlying indexes that define how the funds invest your money.

You'll often find several ETFs with similar names that seem to have the same investment focus. But just because ETFs cover the same sector, it doesn't mean they all use the same index. As a result, sector ETFs won't all perform the same way. How well they do depends on the performance of the component stocks that each fund's index includes -- and those components can vary widely from fund to fund.

Pick of the litter
Once you narrow down a particular sector you want to invest in, the ETF you choose can have a big impact on your returns. Consider, for instance, the energy sector. One ETF, the Energy Select Sector SPDR (NYSE: XLE), has an average annual return of 12.6% for the past five years. Its top two holdings, ExxonMobil (NYSE: XOM) and Chevron (NYSE: CVX), make up about 40% of its portfolio. Low expenses of just 0.22% make the fund act like an index fund, minimizing the drag on returns.

Along similar lines, the iShares Dow Jones US Energy ETF (NYSE: IYE) has a performance record that's almost as good, trailing the SPDR's five-year return by less than half a percentage point. Its allocations look very similar, but its higher expense ratio of 0.48% explains part of its underperformance.

Yet other energy ETFs take much different approaches. PowerShares Dynamic Energy ETF (PXI) hasn't been around as long as its competitors, and its one-year performance trails both the SPDR and iShares offerings. But while the fund's holdings include many of the same names, they're weighted differently. As a result, the fund invests nearly as much money in companies like Transocean (NYSE: RIG), Devon Energy (NYSE: DVN), and Apache (NYSE: APA) as it does in the largest integrated energy companies. If the smaller energy companies outperform their big counterparts, investors will benefit. However, the fund has to overcome a pricey expense ratio of 0.68% to get off the ground.

Look before you leap
Fools, you can't just blindly pick whatever ETF happens to catch your eye in a particular sector. You also have to look inside the fund, to find out what methods it uses to invest your money and how the underlying index picks its components.

In addition, not all ETFs live up to their reputation for low expenses. Without active management, it's tough for an ETF to justify an expense ratio greater than 0.25% or so. A higher price tag would make sense only for certain specialty funds, such as emerging-market international ETFs.

Find out more about ETFs, including:

• The Magical Land of ETFs
• The Easiest Way to Gamble Your Money Away
• Why Investors Are Wrong

Also, take a look at the Fool's ETF Center for the basics on exchange-traded funds.

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