Peter Sander - The 100 Best Exchange-Traded Funds You Can Buy 2012

T HE
BEST
EXCHANGE
TRADED
FUNDS
YOU CAN BUY
2012

PETER SANDER AND SCOTT BOBO

You may have read about it in The Wall Street Journal back in March 2011. Or you may have heard about it elsewhere.

In a public announcement at an asset management conference, investment powerhouse Charles Schwab made public its design for a new type of retirement plan: specifically, a new type of 401(k) plan managed on behalf of its clients. This plan would consist of nothing but exchange-traded fundsETFs for short. Further, Schwab would let its investors tradethat is, buy and sellthose ETFs at no charge.

Weve come a long way, baby.

Way back whenup until the 1970s, anywaystock investing was basically for the richfamous or not. It was a closed and very private alliance between an exclusive set of individuals and their stockbrokers. Those individuals bought individual stocks, largely at their brokers recommendation. They typically paid hundreds of dollars in commissions to buy and sell, so they held onto their stocks for years. Business didnt change as much or as fast in those days, so that was probably okay.

Mutual funds, which were started to provide a managed alternative to individual and some institutional investors, have been around since the 1920s in one form or another. The postWorld War II prosperity led to a boom in saving and investing, combined with tax and compliance clarifications in the Securities Act of 1933 and the Investment Company Act of 1940. Now the average investor didnt have to join the broker club. He or she could buy a mutual fund and expect it to pay for retirementor if the investor also had one of the common legacy pensions, it could finance the American Dream.

The mutual fund in its traditional form first appeared as a fund called the Massachusetts Investors Trust. Now you didnt need a brokeryou just traded with the investment company, usually with a phone call and by mailing checks back and forth. That fund took care of your money and invested it in individual stocks, and a few times a year, you would receive a printed report of what the fund had invested in. It didnt require much time or much expertise.

Trouble is, you didnt know what you were investing in until the report came, which was long after you had invested in the fund (or divested yourself of it). The fund would charge you up-front feessales chargesto get in, and sometimes to get out. It would even levy a nefarious 12b-1 fee as a marketing charge toguess whatmarket the fund to someone else. Sometimes these fees, or load, were buried in the funds performance. You could invest in a no-load fund, but somewhere or another youd still pay anywhere from 1 percent to 2.5 percent or more of the funds value every year for the services of the fund manager.

Still, the commission structure, ambiguities, and time requirements of investing in individual stocks, coupled with an increasing public demand for investments, made mutual funds a real success story. By 1970, some 360 funds were available with combined assets of about $48 billion.

It was the wave of self-directed retirement savings, spearheaded by IRAs and the 401(k), creations of Congress in the early 1980s, that really caused mutual funds to take off.

But some investors were still not happy with the costs and opacities of traditional mutual funds. Some just wanted an inexpensive and easy-to-follow way to invest in a stock index or a selection of stocks, to get the diversification and growth without the time, energy, effort, and cost of buying individual stocks. That cry was first heard by John Bogle of Vanguard Funds in the late 1970s. Vanguard pioneered very low cost index-based mutual funds, which still exist today.

That fund and its brethren spearheaded another leg of the mutual fund boom, which has led to more than 7,000 mutual funds today holding more than $11 trillion in assets.

But investors wanted to reduce costs further and speed and simplify the process of buying and selling funds. They wanted to sell Fund A and buy Fund B at a current market price during the trading day, they wanted to know what that price would be, and they wanted to pay little to no commission. They wanted to use the order placement tools of the day, allowing limit orders, stop loss orders, and so forth.

Indeed, they wanted to buy and sell fundsbundles of stocks or other securitiesjust the way they bought and sold stocks. Online, real time, at the push of a button.

Responding to this demand, State Street Global Advisors (SSGA) came up with an idea. They would create a fund and list it on an exchange. They would buy and sell shares of that fund to and from the general public. The fund would be tied to a popular indexthe Standard & Poors 500 index, and would hold an assortment of stocks as close as possible to the contents and weighting of that index. The investor would know exactly what those stocks were, and how much of each was held. As those stocks rose and fell, the asset value (the net asset value or NAV) of the fund would rise and fall throughout the trading day. Although influenced by other market forces, the price of the fund would move accordingly.

Enter the exchange-traded fund, or ETF.

In this case, it was called the SPDR S&P 500 Trust. This first SPDR came to market in 1993. SPDR stands for S&P Depositary Receipts, a now-arcane phrase that has largely disappeared from the vernacular, although the term SPDR hasnt. In fact, it has become the flagship brand for the 100-plus funds offered by SSGA. It is traded under the ticker symbol SPY and is listed later in this book.

Today, ETFs are the hottest, fastest-growing thing out there. They have grown from humble beginnings in the 1990s to about 1,300 funds managing $1 trillion in assets. Although still smaller in total assets managed, they are giving traditional mutual funds a run for their money.

For many investors, they are also giving individual stocks a run for their money.

As weve made clear in other books in the 100 Best series, we advocateand provide tools forindividual investors to buy and sell individual stocks. We like individual stock investing and think that too many people are afraid of it; it isnt as hard as it looks.

But we also recognize that people dont want to spend all of their time looking at all of their money. They want ways to invest in things like international stocks or emerging country infrastructure or alternative energy without spending the time and overcoming the ambiguities of investing in those rather unfamiliar andwellforeign corners of the investing space.

We think ETFs have a significant role to play for all investors, even for the most sophisticated individual stock investors. ETFs can play a substantial role in any stock portfolio and in any portfolio strategy. And now we have the first all-ETF 401(k) plan on the doorstep.

As with other forms of investment, its important to understand what youre doing, and seek valuethe greatest valuewhere there is value to be had among a number of complex choices.

It is in that spirit that we bring you the first of a new series: