Model Portfolios

As Steven Schoenfeld, author of the book, "Active Index Investing: Maximizing Portfolio Performance and Minimizing Risk through Global Index Strategies," demonstrates in the table below, ETFs can fit into any asset allocation strategy.

For an aggressive portfolio, an investor might have 35% in a large-cap ETF, such as iShares S&P 500 (IVV), 20% in a midcap holding, such as iShares Russell Midcap Index Fund (IWR), 15% in foreign stock, such as iShares MSCI EAFE (EFA), and the remainder of his portfolio sprinkled across some fixed-income and alternative investments, like REITs. A more conservative portfolio might plunk only 15% into a large-cap ETF, 10% into a midcap offering and 5% into international stocks. Instead, the bulk of the holdings would be spread over a variety of bond ETFs, such as iShares Lehman 20+ Year Treasury Bond Index (TLT) and iShares Trust Lehman TIPS Bond Index (TIP).

For investors not looking to overhaul their entire portfolio with ETFs, there are other options. John Kvale, certified financial planner and president of Dallas-based J.K. Financial, often uses ETFs to diversify portfolios that are too focused on one particular area, perhaps a single stock. He also uses them with new investors who are just beginning to build portfolios. Not only is the tax efficiency nice, but he says beginners also find ETFs easy to understand since they simply track indexes. Some of his favorites include Spiders, iShares S&P 500 Barra Growth (IVW), iShares S&P 500 Barra Value (IVE), iShares S&P SmallCap 600 (IJR), iShares S&P SmallCap 600 Barra Growth (IJT), iShares S&P SmallCap 600 Barra Value (IJS) and iShares S&P Europe 350 (IEV).

Another way Kvale uses ETFs is to hold a position in a portfolio. For example, if a mutual fund has underperformed and is being sold for a tax loss, an ETF will be used to rebalance an investor's asset allocation, and essentially "hold" the position (be it small-cap, large-cap and so on) in the overall portfolio.

The pros caution investors to do two things before jumping into ETFs. First, understand what the underlying holdings are. There are more than 130 of them on the market right now — and, just as with mutual funds, competing ETFs could lead to unnecessary overlap if investors aren't careful. Second, remember that the more narrowly defined an ETF is, the riskier it is, says Brian Orol, certified financial planner and president of Raleigh, N.C.-based Strategic Financial Planning Group. "Sector ETFs and country ETFs are by their nature high-risk and aggressive investments," he notes.

The time when ETFs are traded is also something to consider, says Kvale. Liquidity tends to be lighter during the beginning of morning trading and for the last 45 minutes to one hour of regular trading, he says. Because the volume isn't as heavy, the bid and ask prices tend to spread out a bit too much for his liking. "We don't feel we're getting a fair value early in the morning or late in the day," he says.

That's a point mutual-fund investors can't even consider.