Explore Beyond the Core

Most of the cash flowing into exchange-traded funds (ETFs) has focused on a few big funds, especially ones that track popular benchmarks, such as the S&P 500. Such funds are excellent choices for advisors seeking a core holding for clients. But the most intriguing ETFs are the less well-known funds that can increase returns, often while dampening risk.

The way ETFs are structured also allows trading strategies not duplicated by conventional mutual funds. ETFs are based on a passive indexes, often created to represent industry sectors, such as Telecom HOLDRS Trust. Like closed-end mutual funds, ETFs are traded on exchanges and like individual stocks, they are priced throughout the trading day and can be sold short or bought with limit orders.

To appreciate the beauty of the ETF structure, consider an investor who sets out to buy, say, an actively managed small value fund. After enjoying a long spell of strong performance, many conventional mutual funds in the category have been flooded with assets and have closed to new investors. Of the 320 small value funds tracked by Morningstar, 71 have been closed to new investors. While waiting for a favorite fund to reopen, the investor could park the cash in, say, iShares Russell 2000 Value Index, which tracks small value stocks.

To be sure, you can buy conventional mutual funds that track the Russell index. But with some careful trading, the ETF can outperform its conventional competitors, says Al Blomquist, a registered investment advisor in Franklin Lakes, N.J. With a conventional mutual fund, there is no trading during the day: A buyer places an order and takes the shares at the day's closing price. But ETFs trade constantly, and Blomquist often purchases them with limit orders, with a price set by the client. For example, the Russell 2000 Value ETF was recently trading at $193. Given market volatility, an investor who bids $190 has a good chance of acquiring the shares at his price within a week or two. When Blomquist has a client who wants to put $100,000 or more to work, he often makes a series of low-ball limit orders. “This system works well in a choppy market,” says Blomquist.

Besides presenting compelling trading opportunities, ETFs often have the lowest fees. Vanguard Growth VIPERs, a large growth choice, charges a slender expense ratio of 0.15 percent. Retail investors must pay 0.23 percent to buy Vanguard Growth Index, the conventional option; actively managed large growth mutual funds charge an average of more than 1.50 percent. Make no mistake, a no-load fund costs nothing to buy, and investors must pay a brokerage commission to purchase an ETF. But the ETF can be the right choice for many investors. “If you plan on holding an investment for a long time, the ETF could be the better value,” says Noel Archard, a principal of Vanguard Group.

Another fund with rock bottom prices is iShares Goldman Sachs $ InvesTop Corporate Bond, which currently yields 5 percent. The fund owns 100 investment-grade bonds, charging an expense ratio of 0.15 percent, a fee that no conventional corporate bond fund matches. The ETF is particularly cheap compared to the alternative of buying individual corporate bonds. While a retail investor can face steep transaction costs in corporate bond markets, the ETF portfolio enjoys low institutional trading expenses.

Dividend-hungry investors may prefer PowerShares High Yield Equity Dividend Achievers. The fund, which yields 3.5 percent, follows a unique index to deliver income. The index developer starts by compiling a list of all companies that have increased their dividends for at least 10 consecutive years. This collection recently included 304 companies. Then the fund limits the portfolio to the 50 members of the dividend group with the highest yields. “This fund is designed to produce a much higher yield than investors are accustomed to seeing from stock funds,” says Dan Culloton, an analyst with Morningstar.

Culloton cautions that the PowerShares fund is not diversified; 49 percent of assets are in financial stocks, such as Bank of America, and 34 percent of assets are in utilities, such as Consolidated Edison. But investors can use the fund to obtain a growing stream of income. On average, stocks in the portfolio have increased their dividends at an 11 percent annual rate. According to academic research, companies that have increased their dividends for 10 consecutive years are likely to go on raising payouts.

Another unusual choice is PowerShares Golden Dragon Halter USX China. In recent years, buying Chinese stocks has proven to be a rough sport. In some cases, accounting procedures have been irregular and government interference has disrupted markets. PowerShares aims to reduce the risk by holding a collection of 40 stable stocks that get most of their revenues in China but are listed on U.S. exchanges. Such companies must comply with U.S. accounting standards. PowerShares avoids tiny companies and ones with little trading volume. The caution may make the ETF a more compelling choice than conventional competitors that buy shares on Chinese exchanges.

Like Chinese stocks, gold has gained a greater following in recent years as prices have surged. While precious metals are famously volatile, some cautious clients may choose to put a few percentage points of their assets into gold as an insurance policy against a collapse in the dollar or other economic nightmares. Such investors can buy bullion directly, but that requires paying costs for storage and insurance. A cheaper alternative recently appeared with the introduction of streetTRACKS Gold Shares, which has an expense ratio of 0.40 percent. Investors in the ETF own shares in a portfolio of bullion. In contrast, conventional gold funds typically hold shares of mining companies. While the mining companies often track gold, they can be more volatile. Mining stocks sometimes drop when gold prices are rising. This occurs when a company faces operational problems or political instability in its home country. By sticking with the gold ETF, an investor can profit from rises in the metal — and perhaps avoid some of the risks posed by conventional mutual funds.

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