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An All-ETF Portfolio?

In a recent issue of Motley Fool Champion Funds (the investing service that I head up), we outlined an all-ETF portfolio -- a basket of dirt cheap exchange-traded funds that, if indexing purists are to be believed, is virtually destined to beat actively managed rivals over the long haul.

But you know what? I don't believe 'em.

I'm no indexing purist, but I certainly think a model portfolio made up of nothing but bogey trackers serves a useful purpose. However, that purpose isn't to demonstrate that passively managed funds like Vanguard Total Stock Market VIPERs (AMEX: VTI  ) or the popular SPDRs (AMEX: SPY  ) S&P 500 tracker -- both of which are heavily invested (to the tune of 7.4% and 5.6% of net assets, respectively) in the likes of ExxonMobil (NYSE: XOM  ) , Microsoft (Nasdaq: MSFT  ) , and Citigroup (NYSE: C  ) -- are the be-all and end-all of fund investing.

And I feel exactly the same way about bogey trackers that focus on smaller-cap indexes, such as the Russell 2000 or the MSCI U.S. Small Cap 1750 -- benchmarks that currently count Maverick Tube (NYSE: MVK  ) and Level 3 Communications (Nasdaq: LVLT  ) , respectively, among their top constituents.

All or nothing?
In my view, going the index-only route means always having to say you're sorry. After all, the most you can ever legitimately expect with either traditional index funds or ETFs is that, over time, they'll lag the market by about the amount of their expenses.

What's more, I firmly believe that -- beyond just market-cap and growth/value diversification -- savvy investors should aim for strategic diversification. Indexing is just another investing strategy, and as with any strategy, the market will sometimes shine on it and sometimes not. And lately, by the way, it's mostly not been shining on index-only types.

Ebb and flow
Indeed, as USA TODAYreported in January, 2005 marked the seventh year in a row that actively managed funds, as a group, bested the S&P.

In some ways, that particular stat has my inner contrarian salivating. Just as growth investing -- which has lagged value ever since the market's premillennial meltdown -- will someday rise again, so too will index funds. Indeed, it's a safe bet that during some future stretch of time, index funds, as a group, will best active picks once more. Ebb and flow, after all, is practically the market's mantra.

That said, who has the time -- or the inclination -- to try to ferret out which investing strategy is going to be in or out of favor? And what's more, why guess whose turn it is to outshine when active and passive picks can co-exist peacefully and profitably in the same portfolio?

Not coincidentally, the Aggressive, Moderate, and Conservative model portfolios that we track each month in Motley Fool Champion Funds include both active and passive funds, and our "Fund of the Month" recommendations -- all of which are actively managed -- have made light work of the market, besting it by approximately 7.6 percentage points since we first hung out our shingle back in March 2004.

Sneak peek
Ultimately, I think the chief value of an all-ETF portfolio is that it provides one more opportunity to demonstrate the Foolish wisdom of mixing it up with choice active and passive picks, and to take the market's temperature regarding what's working -- and, for all you contrarians out there, what isn't.

If you'd like to take a gander at the initial ETF lineup -- not to mention our complete list of fund recommendations and back-issue archives -- just click here for a risk-free 30-day guest pass. There's no obligation to subscribe, so give Champion Funds a whirl and let us know what you think. Our members-only discussion boards, which also come gratis with the service, exist for just that purpose.

See you there!

This article was originally published on March 9, 2006. It has been updated.

Shannon Zimmerman,lead analyst for Motley Fool Champion Funds, owns shares of Vanguard Total Stock Market. Microsoft is a Motley Fool Inside Value pick. The Fool is investors writing for investors, and you can read all about our disclosure policy right here.

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