New China, Sector ETFs Offer Promise and Peril

Efforts to expand the menu of exchange-traded funds and make them more accessible to smaller investors have received a lot of attention recently. Some of the more prominent new funds include the first mainland China ETF and several new Vanguard sector ETFs. Meanwhile, two firms claim they have found ways to make ETFs more affordable for those who want to make regular monthly investments. A closer look at some of these new funds and developments shows there is something to the hype, but also reason for caution.

The China Syndrome
The iShares FTSE/Xinhua China 25 Index Fund (FXI), which tracks an index of 25 large Chinese companies, has been hailed as the first ETF to offer exposure to stocks on the Middle Kingdom's mainland. Its attractions are clear: There aren't many mutual funds offering pure exposure to China, and this ETF's 0.74% expense ratio is much cheaper than all of them. The China 25 ETF also provides an easier way to negotiate China. Heavy government ownership of many enterprises, a thicket of company share classes, and boom-town atmosphere make it a daunting place to research and pick stocks.

The ETF's dangers are just as apparent. Political and economic uncertainty, as well as extreme portfolio concentration are sure to make the fund volatile. China has been a huge impetus for global growth, but it's still a communist country that faces questions about the sustainability of its expansion, corporate governance of its firms, and integrity of its property rights. With about two dozen holdings, this ETF's bogy also is focused and top-heavy. The fund keeps nearly 60% of its assets in its top 10 holdings and a similar amount in just three sectors: energy, telecommunications, and industrial stocks.

Other China ETFs are in the works, but for now this is the only game in town for investors who want to add a shot of China to their portfolios. Those considering this ETF should note, however, that the Chinese market is coming off a hot streak (the China 25 Index rose 29% on an annualized basis in the 12 months ending Sept. 30, 2004), and that's often the wrong time to invest in an emerging market. Even if the time was right, this offering is best kept on the fringes of a diversified portfolio.

A Growing Nest of VIPERs
The four newest Vanguard ETFs that recently began trading--Vanguard REIT Index VIPERs (VNQ), Vanguard Energy VIPERs (VDE), Vanguard Industrials VIPERs (VIS), and Vanguard Telecommunication Services VIPERs (VOX)--offer cheap exposure to a broad array of stocks in their slices of the market. The fact that they are cheap and offered by an established indexer like Vanguard make these new ETFs immediately competitive with some of the larger ETFs on the market, such as Energy Select Sector SPDR (XLE) and iShares Cohen & Steers Realty Majors (ICF).

They also broaden Vanguard's menu of sector ETFs for investors interested in crafting their own customized asset allocation or sector rotation plans. However, such strategies can be costly to implement and maintain, and these ETFs are still sector funds, which means they can be narrowly focused and concentrated. The Telecom VIPER, for example, keeps two thirds of its assets in its top 10 holdings. These funds, too, are best used sparingly.

Solutions to the Dollar-Cost Averaging Problem?
Brokerage commissions can make it quite costly for investors who regularly invest relatively small sums of money to use ETFs. For many of these investors, buying a no-load index fund direct from a fund company will be much cheaper than using an ETF. Firms are trying to lower the barriers to dollar-cost averaging, though. Oregon-based 401(k) provider "Invest n Retire" offers an online advisory service that helps participants set up and maintain ETF portfolios in their retirement plans. Founder Darwin Abrahamson estimates the firm keeps transaction costs on its ETF portfolios less than 0.30% per year on accounts of about $50,000 by bundling trades.

On another front, online broker Ameritrade recently launched a self-directed ETF wrap account called Amerivest. For an asset-based fee, the system also offers an online advice engine that helps users set up all-ETF portfolios and regularly rebalance or add to them commission-free. Amerivest charges 0.35% on top of the expenses of the underlying ETFs for accounts with balances above $100,000, 0.50% for $20,000 balances, and the lesser of $100 or 2.95% for smaller balances.

Both programs make regular investing in ETFs more affordable, though they are still not necessarily the cheapest option. Most investors could still do better on costs with a portfolio of old-fashioned no-load index funds. For example, a portfolio consisting of  Vanguard Total Stock Market Index (VTSMX),  Vanguard Total Bond Market Index  (VBMFX), and  Vanguard Total International Stock Index  (VGTSX), would have an average expense ratio of about 0.25% and no wrap or brokerage fee.

Disclosure: Barclays Global Investors (BGI), which is owned by Barclays, currently licenses Morningstar's 16 style-based indexes for use in BGI's iShares exchange-traded funds. iShares are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in iShares.