Vanguard's Midcap ETF

23Feb-ETF Focus
Seven Great ETFs

By Rob Wherry Published: January 11, 2007

GOOD FUND MANAGERS always earn their salaries. And the ones in this month's print edition of SmartMoney — click here to see its "35 Best Mutual Funds" list, including seven winners and 28 runners-up — can cash their paychecks with pride.

But it occurred to us that by devoting so much attention to active managers we were ignoring those investors who preferred index funds, especially exchange-traded funds. And as much as those 35 funds had a banner year in 2006, so, too, did the ETF industry. As of Dec. 29, there were 359 ETFs holding $417 billion in their coffers. A year before that date there were just 201 ETFs with $296 billion. Of the new offerings, 112 were specialty and sector funds, products that pushed the envelope on what has traditionally been an index fund alternative.

That means index investors don't need to settle for plain vanilla market returns any more. Granted, the most popular ETFs are still the low-cost, broad-based ones that track established indexes like the Standard & Poor's 500. But a fresh generation of newfangled ETFs may also give investors some extra returns on the margins. Now we have to couch that statement. After all, if you only save for retirement in a 401(k) you won't be seeing ETFs as one of your investment options. That's because you can't dollar cost average into these funds without incurring a trading commission every time you buy one. However, if you also save in a brokerage account via lump sum contributions or use a financial planner, well, you could consider the ETFs on this list as excellent complements to active managers.

Before we get to those funds, though, one reminder about ETFs. You have to pay close attention to the underlying benchmark. For example, the top 10 holdings in the S&P 500 and the Russell 3000 may look the same, but as you drill down, the Russell index has more exposure to small-cap and midcap stocks. That helps performance when those shares are in favor. Indeed, the average annual return of the Russell 3000 over the last three years has outpaced the S&P 500 by a full percentage point.

We mixed a little performance evaluation with expert advice to find ETFs in the same seven categories SmartMoney magazine used in its mutual fund wrap-up. Here are our favorites.

Large-Company ETFs
When it comes to investing in large-cap stocks it's tough to beat the magazine's two favorites. T. Rowe Price's Bob Smith, who manages the company's growth fund (PRGFX), and John Linehan, who helms the value offering (TRVLX), each have good long-term records and work for a shareholder friendly firm. Both funds would make excellent foundations for any portfolio.

Obviously, you could anchor that duo with a broad-based product like SPDRs (SPY), which track the S&P 500. But a more intriguing choice is the Rydex S&P Equal Weight ETF (RSP). This fund weights its portfolio in equal amounts vs. rewarding larger positions to companies with the biggest market capitalizations. This difference means smaller members of the S&P 500 can influence returns just as much as its largest constituents like General Electric (GE), Microsoft (MSFT) or Bank of America (BAC). And that adds up: This ETF has returned 12.5% over the last three years, two-and-a-half percentage points better than the S&P 500 and the T. Rowe Price Growth fund. (Linehan beat that mark by three quarters of a point.) "I think it's a winner," says Rob Lutts, chief investment officer of Cabot Money Management.

We think growth-stock funds — Smith's included — will have a big 2007 after a few years of the doldrums. If you want exposure to large-cap growth stocks consider the iShares Russell 1000 Growth ETF (IWF). It owns about 680 of the largest growth stocks on the market, including Johnson & Johnson (JNJ), General Electric and Intel (INTC). While you won't get Smith's stock-picking prowess, you will get a fund that has many of the same holdings at a fraction of the cost. The iShares offering charges an expense ratio of 0.20%, vs. 0.72% for T. Rowe Price Growth.

Midsize-Company ETFs
Over the last five years the MidCap SPDRs ETF (MDY) has kept pace with Meridian Growth (MERDX), the magazine's top pick in this category. They both have average annual returns around 10.3% over that time period. But we would opt instead for Vanguard's Midcap ETF (VO). Why? The Vanguard offering uses the Morgan Stanley Capital International 450 index, which gives investors access to a wider swath of companies with larger market capitalizations. The Vanguard ETF also charges 0.13% — one of the lowest fees in this category — compared with 0.25% for the SPDRs. Performance also swayed us. The Vanguard MidCap returned 9% last year, three percentage points better than the Midcap SPDRs. (Although, Meridian beat them both in 2006 with a 14.7% showing.)
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