When it comes to low-cost investing, it's hard to beat an index fund. By providing investors with a diversified portfolio of stocks in one package, index funds revolutionized the way small investors put their money to work and have served as a model for a number of advances in financial innovation, most notably the exchange-traded fund (ETF).

But in some sectors of the market, index funds and ETFs simply aren't the best way to gain exposure to a particular type of investment. By owning the entire index, you lose the ability to pick and choose among the individual components -- and sometimes, that leaves you with stocks you really don't want in your portfolio.

Finding the REIT stuff
As an example, consider real estate investment trusts. REITs are creations of the tax code, giving companies that invest predominantly in real estate assets an advantage over corporations in other lines of business. If a company agrees to pay out at least 90% of its net income in the form of a dividend to shareholders, then it can qualify for REIT status and avoid having to pay a corporate-level income tax on its earnings. That in turn benefits shareholders; although they have to pay tax on the dividends they receive, they don't suffer from the double taxation that most U.S. corporations bear.

You can own small portions of members of the entire REIT universe through ETFs. For instance, I own shares of the Vanguard REIT Index ETF (NYSE: VNQ), which holds almost 100 different REITs. At a cost of just 0.13% annually in management fees, you'd be hard-pressed to find a more efficient way to quickly add diversified REIT exposure to your portfolio.

REIT for you, wrong for me
If you look more closely at Vanguard's REIT ETF, though, you can see some shortcomings to owning a broad-based REIT portfolio. Although a REIT index may seem like it includes just a single category of companies, it actually combines several different types of REITs with vastly different characteristics.

In particular, you'll find these categories of REITs inside most ETFs covering the sector:

  • Retail REITs. These companies typically own malls or shopping centers. They earn profits by leasing space to retailers. For instance, Simon Property Group (NYSE: SPG) is the largest owner of shopping malls in the U.S., and its fortunes are therefore tied to the shopping behavior of consumers across the nation.
  • Office REITs. These companies own office buildings and lease space to businesses. An example is Boston Properties (NYSE: BXP), which owns properties not only in Boston, but also New York, Washington, and San Francisco. Office REITs are particularly vulnerable to economic downturns generally, as well as gluts created during building booms.
  • Industrial REITs. Similar in some ways to office REITs, these companies provide customized space that businesses use for specialized purposes. Prologis (NYSE: PLD), for example, helps build distribution centers to help customers manage their logistics. Because these companies end up working more closely with their customers to customize properties, turnover is lower. But industrial REITs have also been slower than other types of REITs to recover as the economy rebounds.
  • Residential REITs. Companies like Equity Residential and AvalonBay Communities (NYSE: AVB) manage multifamily residential properties. These investments tend to be particularly location-specific, as cities go in and out of favor as places to live.
  • Specialty and diversified REITs. This catch-all category includes everything from mortgage-backed securities buyer Annaly Capital (NYSE: NLY) to forest products maker Weyerhaeuser (NYSE: WY). How these REITs behave is specific to each one's focus.

Vanguard's REIT index includes companies in each of these sectors. That's great if you like them all, but if you rely on the ETF, you can't favor residential or mortgage REITs over retail or office REITs. Given how different each subsector of the REIT universe behaves, you can miss some opportunities if you own all of them.

Get the exposure you want
ETFs are great ways to invest, but they have their limitations. In some cases, the diversification ETFs offer means that you end up owning companies you don't really want in your portfolio. If you favor one part of a sector over another, then the better way to tailor your investments is simply to buy the individual stocks you like directly.

Follow Vanguard's REIT Index ETF by adding it to your version of My Watchlist, the Fool's new, free investment tracking service.

Fool contributor Dan Caplinger is a punny guy. He owns shares of Vanguard REIT Index ETF. The Fool owns shares of Annaly Capital Management. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy never stops looking for the best way to play.