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Exchange-traded funds started out as a great low-cost answer to higher-priced mutual funds. Now that they've gotten popular, though, Wall Street is trying to warp the biggest advantage ETFs have to its own ends by introducing new products with higher management fees.
If you're smart, though, you won't play their game. There are still plenty of ETFs that are more interested in giving you easy access to a diversified portfolio than in taking every penny they can get in fees.
The ETF evolution
ETFs evolved out of a simple idea: create an index-tracking investment that trades throughout the day on stock exchanges. The first ETFs were broad-market index trackers, designed to mimic both the popularity and the low cost of index mutual funds. For years, ETFs tracking big indexes like the S&P 500 were the only ones available, yet their high trading volumes showed just how useful investors found them in implementing their investment strategies.
As the ETF market continued to develop, offerings became ever more specialized. The first sector ETFs focused on already-existing indexes, but as the demand for niche products increased, ETF providers created new indexes solely to facilitate new ETFs to track them.
More annoying, though, was the fact that these second- and third-generation ETFs were in many cases much more expensive than their ancestors. Nowadays, it's not uncommon to find ETFs charging close to 1% annually in management fees -- more than many mutual funds cost. And this is still for ETFs that passively track indexes; with actively managed ETFs still in their infancy, the potential for even higher fees down the road looks inevitable.
Fortunately, though, you don't have to fall prey to these higher fees. Here's a group of good low-cost ETFs that watch out for your bottom line.
1. SPDR S&P 500 (NYSE: SPY )
The grandfather of ETFs, Spyders are still a bargain. The ETF tracks the favorite of all U.S. index funds, the S&P 500. And it does its job cheaply, charging just 0.09% annually.
It's true that you can find broad-market ETFs from Vanguard and iShares that are just as cheap or even cheaper. But none of those alternatives has the liquidity that SPDRs have, trading over 200 million shares daily. Sometimes, the old way is the best way.
2. PowerShares QQQ (Nasdaq: QQQQ )
The so-called "Cubes" track the Nasdaq 100 index, which consists primarily of technology companies. Even though its heyday came right after its introduction in 1999 during the tech boom, Cubes are still popular, trading billions of dollars in shares every day. And even though its 0.20% expense ratio is pricier than the S&P, it's still a reasonable alternative to actively managed tech mutual funds.
3. iShares Russell 2000 (NYSE: IWM )
If you only buy an S&P 500 ETF, you miss out on the power of small-cap stocks. That's where this iShares offering comes in, giving you access to nearly 2,000 up-and-coming companies. All you'll pay is 0.20% per year, and with a Fidelity brokerage account, you don't even have to pay commissions to buy shares.
4. Vanguard Emerging Markets Stock (NYSE: VWO )
Investing in foreign stocks is traditionally much more expensive than staying close to home, but this ETF lets you in on all the hottest stocks in emerging market countries like China, Brazil, and India. Annual expenses of 0.27% are on the high side for this list, but they pale in comparison to some other popular emerging-markets ETFs.
5. iShares iBoxx Investment Grade Corporate Bond (NYSE: LQD )
Bonds are hot right now, and with Treasuries already having seen yields plummet, many investors are looking to corporate bonds for higher income. With bond funds, low expenses are all-important, and this ETF fits the bill with just a 0.15% annual fee.
6. Vanguard REIT Index (NYSE: VNQ )
Going beyond traditional bond funds for fixed income is especially important when rates are low, and this real-estate based ETF is a good answer for those seeking to diversify. Its 0.13% expense ratio won't burden you on the cost side either.
A combination of these six funds would make a reasonably balanced portfolio. You can also find many cheap alternatives from Charles Schwab (NYSE: SCHW ) , also with a commission-free feature like Vanguard's and Fidelity's. In contrast, many new ETFs not only charge you several times as much but also are based on untested indexes. You don't need to pay up to be the guinea pig for a new investing strategy.
ETFs are convenient and useful, but you shouldn't overpay for them. Stick with tried-and-true low cost ETFs, and you'll do yourself a favor for years to come.
If you use ETFs, you have to stay away from scary sectors. Rick Munarriz has the scoop on three plays you should avoid right now.
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When it comes to getting ripped off, Fool contributor Dan Caplinger holds a grudge. He owns shares of the two Vanguard ETFs mentioned in this article, as well as iShares Russell 2000. Charles Schwab is a Motley Fool Stock Advisor choice. The Fool owns shares of Vanguard Emerging Markets Stock ETF. Try any of our Foolish newsletters today, free for 30 days. The Fool's disclosure policy knows a great deal when it sees one.