Chances are, you already own a portfolio of mutual funds. So, how would exchange-traded funds fit into the picture? For starters, ETFs are still struggling to break into company retirement plans, so you're not likely to find them on your 401(k) menu. But in a taxable account or an IRA, it's not an either-or proposition; just like peanut butter and jelly, mutual funds and ETFs can coexist—and even be complementary.
Some investors have fully converted to all-ETF portfolios, but many use ETFs to represent just one or two positions. That might mean adding an industry-specific ETF or replacing an actively managed mutual fund that has consistently failed to beat its benchmark index. Tom Lydon, coauthor of the book iMoney: Profitable ETF Strategies for Every Investor, points out that, on average, active managers weren't earning their keep, even before the current market meltdown. Over the five years that ended last June 30, the S&P 500-stock index beat out roughly 70 percent of actively managed large-company funds, according to S&P. International funds and bond funds lagged behind their benchmarks by even more (87 percent and just over 75 percent, respectively).
"If you look back even 10 years, your positions are probably down," says Lydon, who is president of Global Trends Investments of Newport Beach, Calif. "There's nothing you can do to change that, but you can readjust going forward."
If you need to rebalance your portfolio, now's the time do it, Lydon says. The upside to selling and buying now is that you can purchase many ETFs at deep discounts. And if your mutual fund is gearing up for a big year-end capital-gains distribution (and has consistently straggled behind its benchmark), Lydon recommends replacing it with an ETF in a similar asset class. "Plus, you've got a loss you can use to write off future gains," he says. As with mutual funds, you can write off investment losses up to $3,000 and losses beyond that can be carried forward to future years.
When it comes to the basics, building a portfolio with ETFs isn't much different than with traditional mutual funds. There are two important things to keep in mind, however. Because ETFs trade on exchanges like stocks, you pay broker commissions to buy or sell them, which can set you back as much as $15 per transaction on each end (some brokers charge much less, or nothing at all if you meet certain guidelines). That's why buying and holding ETFs is the most cost-effective approach.
The long view. Most vital to your long-term performance is how you divvy up your money between stocks and bonds. Over the long haul, stocks clearly provide the best returns. Since 1926, large-company stocks have gained an average of 10 percent per year, according to Morningstar. During the same period, bonds returned an annualized 6 percent and cash just 4 percent. With inflation averaging 3 percent a year since 1926, your real, after-inflation return drops to 7 percent for stocks, 3 percent for bonds, and just 1 percent for cash.
Because different types of stocks take turns leading the market—and those shifts are largely unpredictable—it makes sense to keep your portfolio stocked with ETFs representing both U.S. and international stocks, plus a variety of investing styles and company sizes. For example, you'll want to include ETFs that hold fast-growing companies, plus those that track apparently undervalued firms (some ETFs invest in a combination of both). The same goes for just about every major asset class.
Ultimately, your portfolio allocation also hinges on a number of factors, including financial goals, age, life expectancy, and your ability to tolerate risk. In the graphic on this page, Lydon provides model portfolios for three major life stages. The suggested ETFs are just that, he says; mixing and matching are encouraged.