PENNY MARLIN HAS over two decades' worth of experience as a financial advisor. Two years ago she decided to open her own shop in Delray Beach, Fla., a coastal town about an hour north of Miami that's popular with retiring baby boomers. She oversees $12 million that's invested in index and actively run mutual funds. However, she has been increasingly favoring exchange-traded funds as a cheap and easy way to get exposure to every part of the stock market. "I'm constantly making comparisons," she says.

One thousand miles away is Clark Capital Management, a $1.2 billion advisory headquartered in a sprawling steel and glass tower that dominates Philadelphia's skyline. The company's experts can pump their clients' money into a variety of sophisticated investments, including hedge-fund products. But this firm, too, has been using ETFs to play the market. "They've become more and more the mainstream," says Sean Clark, the firm's chief investment officer. "We've never had an issue with liquidity."

Exchange-traded funds are at the center of one of the biggest transformations in the indexing world, a no-frills fund category that was launched by Vanguard in 1976. As ETFs have spread to every corner of the stock market, both here and abroad, financial advisors small and large have been turning to these products for their flexibility, tax efficiency, low cost and, in some cases, market-beating returns. A decade ago 19 ETFs held a measly $6.7 billion. Now there are 545, according to State Street, that hold $505 billion. That's still a small sliver of the $10 trillion sitting in mutual funds, but the impact has been swift and dramatic.

With the ETF universe growing at warp speed, we wondered: Could you now create an all-ETF portfolio? More specifically, would you want to? All-ETF portfolios come with their own set of risks and rewards and not every investor can pull one off successfully. That's why we interviewed financial advisors from across the country to see how they would put together portfolios that would fit not only an investor heading toward retirement but also one who can stand a little more risk.

To do so, we made some assumptions about who would be ideally suited for such an exercise. For example, if you invest for retirement solely in a 401(k) then the following models won't make much sense, since you can't dollar-cost average into an ETF like you can a mutual fund. The trading commissions are prohibitive. That's one of the reasons why you won't see an ETF in your 401(k) at least not yet. And if you are a buy-and-hold type you may be able to do just as well by sticking with the tried and true index mutual funds at shops like Vanguard. But if you have some extra cash and can invest it in one big lump sum or if you want to diversify outside the funds in your 401(k), then an all-ETF portfolio might be an intriguing option.

That's because ETFs offer some attractive advantages over other investments. For one, you don't have to worry about finding the best pharmaceutical or retail stock, for example. Just buy the industry ETF. In addition, since ETFs constantly change hands you can jump in and out of the market quickly, a huge selling point for active traders. In most cases, they can also be shorted. And for the most part they charge cheap fees and have better tax efficiency than mutual funds since their low turnover doesn't typically lead to big capital-gains hits. A new generation of ETFs is even allowing small-time investors to get access to some sophisticated strategies that in the past were reserved for a select few. That puts Marlin on a level playing field with her bigger competitor in Philly.

In the wrong hands, though, those benefits can actually cause problems. After all, the original idea behind index funds was to give investors access to the entire market through a product that shunned sales and marketing charges while eliminating turnover. Being able to trade index funds throughout the day in addition to shorting them, too is anathema to John Bogle, Vanguard's founder. "If long-term investing was the paradigm for the classic index fund," he said in a Wall Street Journal opinion piece last week, "trading ETFs can only be described as short-term speculation." He has a point. Most of the newer products are untested and designed with institutional or hedge-fund clients in mind. Today, many ETFs track benchmarks that didn't exist just two years ago. Finally, there's also a profit motive at play here: ETFs generate about $1 billion in management fees. That doesn't include the trading commissions that fall into the pockets of brokerages and wire houses.

But even Bogle had his doubters at the beginning. We're about to see one of the largest chunks of ETFs celebrate their third birthday, an important starting point for studying long-term performance. And while there are clunkers on the market, there are also just as many ETFs that have proven their mettle. That doesn't mean your favorite fund manager will be out of a job any time soon. Many advisors still prefer putting their money with an expert whose skills have been honed over decades dealing with the market. However, it should serve as a reminder to all those high-priced laggards out there that better returns at lower costs are an easily obtainable option for every type of smart investor.

The Conservative Approach

Once you have done your homework it will quickly become apparent that there are two essential products to any standard ETF portfolio: One that tracks the market cap weighted S&P 500 index, and another that does the same for an international bogey. Consider these funds the core of your portfolio, garnering maybe 50% of your assets if not more. They'll give you broad exposure to the stock market while charging some of the lowest fees around. (A quick reminder: You'll be creating a redundant portfolio if you already own these types of funds in another account.)

The most popular option for U.S. exposure is also the oldest ETF out there: State Street's

SPDR

Vanguard Total Stock Market

iShares MSCI EAFE ETF

BP

Toyota

UBS

Nokia

You can round out those core holdings with new fixed-income ETFs that were just released by iShares. These offerings track well-established Lehman bond indexes that cover corporate and government paper, along with Treasurys in various durations. These funds charge between 0.15% and 0.20%.

Take It Up a Notch

If that approach is too conservative you could take on some additional risk by selecting some ETFs that specialize in certain stocks, like growth firms or value plays. Value has been a big winner the last few years. Since 2004 the

iShares S&P 500 Value ETF

Powershares Dividend Achievers ETF

You don't need to limit your portfolio to large-company stocks. You should also have around 10% in small and midsize firms, too. If you don't get your fill of these niches with one of the total stock market or Russell ETFs, you could purchase the iShares S&P MidCap 400, which invests in companies with market capitalizations between $1 billion and $4 billion. A sister fund is the iShares S&P Small Cap 600. It tracks firms with market caps smaller than $1 billion but larger than $300 million. Both have outperformed the S&P 500 over the last five years.

That makeup about 50% of your assets in a broad market ETF, complemented by another 20% to 30% in growth, value, small or mid is a solid start for any portfolio, according to our experts. But what about something with a little more juice?

Risk(ier) Business

Sector ETFs are one way to put your portfolio into high gear. Most fund families have ETFs that track energy, technology, consumer staples, utilities, financial services and health care, among other industries. Making the right bet on a part of the market can pay off big. Indeed, a $1,000 investment in the

Energy Select SPDR

Technology Select SPDR

Another smart idea is to diversify overseas. The Vanguard Emerging Markets Stock ETF is a perfect way to complement the iShares EAFE. This Vanguard product invests in 800 companies in countries throughout Asia, in Russia, South Korea and Taiwan. Top holdings include Samsung, Mexican cellphone operator America Movil and Russian oil giant Lukoil. It returned 30% last year, its first 12 months on the market. "This is how I have been getting my emerging-market exposure," says Marlin. "Vanguard's expenses are significantly lower than [it competitors]."

There were other launches in 2006, too. And some of these blurred the lines between passive investments and actively run funds. While some of these newbies are intriguing, our experts think many of them are not worth of your hard-earned cash at least not until they have proven themselves. "Some of these new ETFs are just about throwing an idea against the wall and hoping that it sticks," says Jeff Beutow, chief investment officer for XTF Advisors in New York. Two core-type holdings to keep an eye on are the Rydex S&P Equal Weight, which gives equal billing to every member in its portfolio vs. the traditional market-cap-weighted approach, and the PowerShares FTSE RAFI U.S. 1000, which determines the size of its positions based on a myriad of factors like revenues, dividends and cash flow. The Powershares product, one of the more debated ones due to its quasi-active feel, returned 19% last year, three percentage points better than the S&P 500. But it also charges a rich 0.76% expense ratio. The Rydex fund has beaten the traditional S&P 500 by four percentage points since 2004 and only charges a 0.40% expense ratio. "This is where it gets interesting," says Darin Pope of investment shop United Atlantic in Seacaucus, N.J. "You really need to ask yourself where you cross the line [into active management.]"

After that, it gets a little dicey. Just this year ETFs have come out that allow investors to slice and dice the health-care industry by specialties that include infectious diseases and cancer. Claymore, a relatively new player in the industry, has ETFs that are built around spin-offs and firms that have large patent holdings. Other firms are planning on weighting companies based on revenues and earnings. ProShares allows shareholders to aggressively short and go long the market. And get ready for funds that will narrowly segment countries around the world by style, size and industry. But in the end you have to ask yourself if you really need to invest in any of these exotic ETFs. After all, its one thing to put some extra cash to work building an all-ETF portfolio, but it's another to lose it all on a bad call.