In the first two tips in this series, we've focused mainly on the potential downsides of exchange-traded funds (ETF), namely that they don't make a lot sense for dollar-cost averagers and that the ETF industry has a bad habit of cranking out "products" that hardly anyone needs.
Rest assured, though, that I'm actually a big fan of ETFs. As the chief analyst for the Fool's Champion Funds newsletter service, I've been pleased as punch by the price pressure that ETFs, with their typically lower expense ratios, have applied to traditional index funds.
Last year, for instance, Fidelity slashed the price tags of such bogey-tracking stalwarts as Spartan 500 Index (FUND:FSMKX) -- an S&P tracker that provides exposure to the likes of Cisco (NASDAQ:CSCO), Coca-Cola (NYSE:KO), ExxonMobil (NYSE:XOM), and AIG (NYSE:AIG) -- and Spartan International -- a fund that tracks the MSCI EAFE index -- partly in a bid to head off the ETF juggernaut. As a result, both of those funds now go for a paltry 0.10%.
Beyond that, though, if you know where to look, ETFs can make great buy-to-hold investments. They offer cheap and easy access to the market's various cap ranges and styles, and provided you've come up with an intelligent asset allocation game plan, slotting tried-and-true ETFs such as Spiders (AMEX:SPY) and Cubes (NASDAQ:QQQQ) into your personalized pie chart is relatively light work.
What isn't quite as easy is maintaining that pie chart in a way that jibes with your investment timeline and tolerance for risk.
In the short run, at any rate, the market can move in mysterious ways. Who'd have thunk that smaller-cap stocks would have bested the big boys for so long? Or that value stocks would continue to outpace growth, despite valuations that, on the whole, make growth look relatively cheap?
Market fluctuations affect traditional fund investors, too, but at least they have the advantage of a manager who earns his keep in part by fretting over price multiples and selling -- or at least trimming -- holdings whose valuations have gotten rich.
Not so ETF investors. Owners of these puppies are their own fund managers, and thus rejiggering their portfolios to account for a certain market segment's run-up (or sell-off) is their exclusive responsibility. Rebalancing, of course, is important for investors of all stripes. But if you own ETFs, you may be reluctant to do it because you'll incur transaction costs each time you buy and sell shares. But you shouldn't be. The proper care and feeding of ETFs absolutely involves periodic rebalancing.
The bottom line: Handy though they are, ETFs simply aren't set-'em-and-forget-'em investment vehicles.
Next up: Why it makes sense to own both index trackers and actively managed funds.
Shannon Zimmerman covers index funds, ETFs, and actively managed picks in the Fool's Champion Funds newsletter service, which you can test-drive free for 30 days. Shannon owns no securities mentioned.
