In 1989 the first ETF—Index Participation Shares—came to the rescue. This S&P 500 proxy traded on the American Stock Exchange but was quickly gunned down by the Chicago Mercantile Exchange who quickly perceived the threat. It wasn’t until 1993 that the real gunslinger rode into town and changed the order of the fund industry forever.

The Good ETFs. In 1993, SPDR S&P 500 (symbol SPY) was launched on the New York Stock Exchange. Known as SPDRs or “Spiders,” the fund became the largest ETF in the world. In just over 15 years, there are now close to 1000 ETFs with more than $1 trillion in assets and growing at a breakneck pace close to 30 percent year-over-year.

But just when ETFs were winning the day, the ETF industry drifted from its sound mooring after the SEC approved a redefinition of the term “index” in 2003. Before then, ETFs were limited to holding baskets of stocks that tracked broad market indices such as the S&P 500 or MSCI EAFE for foreign developed country markets. After 2003, the SEC allowed ETF providers to create any set of guiding rules to form newfangled “indices.” This changed the definition of an index and allowed the Wall Street crowd to run wild creating the latest, greatest “index” de jour, cluttering the universe of good ETFs with a never-ending wave of convoluted, bad, and in some cases, downright ugly ETFs.

When trying to make sense of the world of ETFs, there are five simple principles that will guide you to the good and away from the bad and ugly:

• Index construction. Evaluate each ETF for the quality of the index it tracks and how well the provider replicates the given index’s performance over a long period of time. A bad index means a bad ETF.
• Low management fees. Be sure that you are paying rational management fees for the asset class under consideration. In general, the lower your fee the more you stand to make over time.
• High volumes. Quality ETFs often average billions of dollars in net assets where daily volume runs very high. This affords sufficient volume and liquidity so that the bid/ask spreads are narrow.
• Low turnover. More turnover means more taxable income. Look for turnover to be very low, about 10 percent for equity ETFs. Turnover is generally greater for bond ETFs because bonds mature and need to be continually replaced.
• Quality sponsors. Look to Vanguard, iShares, SPDRs, and Schwab ETFs for quality funds. These four firms account for close to 90 percent of all ETF assets and are highly regarded in the industry. Since Vanguard is a not-for-profit institution with the lowest fees in the industry, they tend to keep the other ETF providers “honest.”

The bad and the ugly ETFs. With new indexes popping up daily, the original “purity” of ETFs as suitable building blocks for asset allocation has been polluted. One of the most extreme examples of this is an ETF released in 2007 (now closed) by FocusShares, which developed an index of mid- and large-sized companies consisting of casinos, producers of beer and malt liquors, distillers, vintners, as well as cigarette manufacturers, and called it a “sin” index. Below is a list of potentially bad and ugly ETF categories to watch out for:

• Leveraged ETFs. While ProShares launched the first leveraged ETFs, a subsequent wave of leveraged products have followed. Strangely, these leveraged products have been known to sometimes severely miss the index over the long haul. Because daily returns are compounded, the returns of leveraged ETFs over periods longer than one day will likely differ in amount. And leverage is dangerous. Take for instance Direxion Daily Financial Bear 3X Shares (symbol FAZ), which plunged 95 percent, earning it the ignominious title of worst performing ETF in 2009.
• Actively-managed ETFs. It has been said that “if you can’t beat ‘em, join ‘em.” Well this seems to be the case with many active money managers that are now moving their practices from the mutual fund industry over to the ETF space. ETFs with a portfolio manager face the same challenges that mutual funds face—high fees and poor long-term performance records.
• Commodity ETFs. These hold futures contracts. Avoid ETFs that buy future contracts to achieve commodity exposure. Futures-based funds can fail to track their target index and are vulnerable to problems such as contango and backwardation. It is best to avoid such ETFs and stick with commodity ETFs that actually hold the underlying assets.

For you investment geeks who want a more comprehensive discussion on how we’ve used this to pick the ETFs for our MarketRiders portfolios, click here. When it comes to ETFs, invest in the good and avoid the bad and ugly. As tempting as the newfangled ETFs can be, the details reveal serious investment risks. By sticking with the five principles to finding good ETFs you can invest with confidence knowing that you have kept the bandit out of your portfolio.

A commodity is something for which there is demand, but which is supplied without any real difference across a given market. Commodities prices are determined as a function of their market as a whole. Generally, these are agricultural products, energy, gold and silver, and industrial metals.

Commodities can be an important hedge against inflation and devaluing currencies. The continuing strong growth in the global economy has created strong demand for a variety of raw materials, from oil to metals to lumber. That demand, in turn, puts upward pressure on the prices of those commodities. Because commodities prices usually rise when inflation is accelerating, they offer protection from the effects of inflation. Few assets benefit from rising inflation, particularly unexpected inflation.

Commodities have offered superior returns in the past, but they carry a higher risk than most other equity investments. However, by adding commodities to a portfolio of assets that are less volatile, you can actually decrease the overall portfolio risk. That’s because commodities have a low correlation to other asset classes.

With such volatility in mind, we add commodities as an asset class on our more aggressive equity-biased portfolios and only invest in commodities that are in permanent limited supply: energy and gold. Our portfolios include the iShares S&P Global Energy Sector (IXC) and SPDR Gold Trust (GLD).

The iShares fund gives you ownership of 86 energy companies worldwide-about half in the United States and half in countries like the U.K., Canada, and China. You’ll own the major companies that produce oil and gas, distribute oil and gas (Exxon, Chevron, Petrochina), as well as those that service the industry (Schlumberger), and others like Murphy Oil and Canadian Oil Sands Trust.

The profits generated from these businesses tend to directly correlate with the price of oil and gas, which is how you get exposure to the underlying commodity prices. Commodity ETFs are cheaper than many traditional commodity mutual funds. High-priced energy mutual funds like the Calvert Global Alternative Energy Fund (CGAEX), which charges annual fees of 1.85 percent; Fidelity Advisor Energy (FAGNX), which carries fees of 1.45 percent; or ICON Energy (ICENX), which charges 1.26 percent, all levy about three times the fees of IXC (0.48 percent) because investment pros are trying to pick the winners. But with IXC, you own a broader mix of companies and you will make more money over time just because of the savings in fees.

In the case of gold, silver, and other precious metals, before the advent of ETFs, investors had to own the physical metal. The GLD fund enables anyone to own a part of an index based on the physical metal stored in secure warehouses. Most mutual funds charge two to three times more than GLD’s 0.4 percent fee, like First Eagle Gold (FEGOX), which has annual fees of 1.21 percent, and Franklin Gold and Precious Metals (FKRCX), at 1.02 percent.

Most negative publicity surrounding ETFs focuses on commodity funds. They can be very dangerous for retirement-focused investors (rather than traders) because many of these ETFs are composed of baskets of commodity futures instead of physical commodities or actual companies. Long-term, passive investors should avoid some popular index products like the United States Oil Fund (USO), the United States Natural Gas Fund (UNG), iPath Dow Jones-UBS Commodity Index (DJP), and others that hold futures contracts. Investors including hedge-fund operator Michael Masters have been actively lobbying regulators to rid the market of these ETFs because they distort prices and artificially drive up prices. They are both damaging to the system and to the retirement investor’s portfolio.

If you want to stray beyond our model portfolios, consider ETFs like the Energy Select Sector SPDR (XLE), Oil Services HOLDRs (OIH), and iShares Dow Jones U.S. Oil Equipment & Services Index Fund (IEZ) that hold shares of real operating businesses. Also, buy commodity ETFs from only the three largest sponsors: Vanguard, iShares, and State Street (SPDR).

The original ETFs were simply baskets of stocks that represent a widely known index (like the S&P 500), wrapped into a single security that could be traded like any other stock on the exchange. For a variety of reasons, the financial industry has been manufacturing exotic ETFs at a feverous pace, stretching the meaning of the term “index,” and these ETFs are designed for active traders. For investors seeking a common sense, low-cost, globally diversified portfolio for retirement, there are only 20 or so ETFs that are needed to gain exposure to most asset classes, and the two mentioned earlier in this article should give you all the exposure you need to commodities.

In 2008 it turns out that asset allocation decisions have everything to do with a portfolio performance.

On MarketRiders, we use our own ETF portfolio builder to track some “Celebrity Portfolios” including the “Lazy Portfolios” (published by Paul B. Farrell at Marketwatch). These portfolios mimic allocations based upon Yale University’s David Swensen, Dr. William Bernstein, Ted Aronson, and Bill Schulthesis who wrote “The Coffeehouse Investor.” Community members also have posted many interesting portfolios with unique asset allocations that have held up well in the last few months.

These portfolios use ETFs without active management and we track weighted average portfolio fees. The component ETF fees range from .08% to .50% and the weighted average portfolio fees are between .12% and .21%.

Comparing and contrasting portfolios with similar asset allocations, shows a lot about how to build solid “all weather” allocations that have held up even in 2008. While some of the variance is surely explained by the allocation in non-equities (Bonds, Treasury Inflation Protected Bonds and Cash), a lot of it is explained by the level of diversification amongst the other asset classes.

There’s quite a variance between some of the portfolios – even when their equity exposures are similar. Two portfolios each with 60% equity exposure have dramatically different results.

For example, Bill Schulthesis, a ex-Salomon Smith Barney broker who wrote The Coffeehouse Investor, designed a portfolio with 40% in an intermediate bond index (BND) and 10% in each of 6 stock funds (Vanguad REIT ETF (VNQ), SPDR S&P 500 ETF (SPY), Vanguard Small-Cap ETF (VB), Vanguard Small-Cap Value ETF (VBR), Vanguard Value ETF (VTV), Vanguard FTSE All World ex-US ETF (VEU)). Dr. William Bernstein wrote the “Intelligent Asset Allocator” and “The Four Pillars of Investing” and proposed the same basic allocation. But high exposure to small cap value US stocks and REITs allowed Coffeehouse’s returns to trump Bernstein by over 2 times.

Here are the results as of last night’s close.  These portfolios and the ETFs in them are posted on MarketRiders.

The Best and the Worst Returns

To better understand where the variances lie, we drill down into each asset class to see where returns (or lack thereof) are coming from. Aronson’s portfolio, is the worst so far, down (16.65%) with 80% equity exposure. Unfortunately, Aronson had no REIT exposure and heavy exposure to Emerging Market (VWO) and Foreign Markets (European (VGK) and Pacific (VPL)) which have both been crushed this year. Aronson’s portfolio has performed very well for 5 years on the backs of these asset classes, but 2008 has been his come-uppance.

The MarketRiders “Low Risk” portfolio is doing the best so far this year – down only (1.83%) – but with 25% exposure to equity and Real Estate (RWR). A strong US allocation (iShares S&P SmallCap 600 Index  (IJR) and SPY) over Foreign Developed and Emerging Markets (VEU) helped dampen the losses.

It’s Time to Rebalance!

Today, we’re rebalancing a few of these portfolios where actual allocations now vary greater than 20% off our targets. The most out of balance portfolio is the one built by John Spense and Rick Ferri on MarketWatch. Emerging Markets, Foreign Markets, TIPs and Small Cap US stocks are all out of whack so this portfolio and others will be brought back to their targets.

Stay tuned.  At the end of the year, we’ll report back and show you how these portfolios did.