Exchange traded funds are revolutionizing how we invest.

    An exchange traded fund, as the name suggests, trades like a common stock. That means you can buy or sell shares at any time during the day. The difference is that an ETF is a portfolio of stocks (or bonds) that mimics an index. Just as the first index mutual fund mimicked the Standard and Poor’s 500 Index, the first exchange traded fund mimics the Standard and Poor’s 500 Index. Launched in 1993, the SPDR Trust (ticker: SPY) now has nearly $50 billion in assets. That puts it among the ten largest mutual funds. 

    The growth of ETFs has been stunning. When index mutual funds had been around for ten years there were only seven funds. ETFs grew to 108 in the same time period. Today, over 177 ETFs trade in U.S. markets.  More are on the way.

    What makes them so attractive?

    Low cost, liquidity, diversification, and instant ownership. True, you have to pay a brokerage commission to buy or sell ETF shares. But commissions are a trivial expense for many investors.

    Here’s the math. You can buy Vanguard 500 Index mutual fund shares at an expense ratio of 0.18 percent, no load. The original SPDR Trust ETF reproduces the same index and has an expense ratio of 0.10 percent. Do a $10,000 trade with an $8  commission and you’ll recover the commission in 12 months on the expense ratio difference.  After that, you save money.

    You can set up my Margarita Portfolio for $24 in commissions and it will have an average annual expense ratio of 22 basis points (0.22 percent). Named in honor of Jimmy Buffett, not Warren, this portfolio is 1/3 domestic equities, 1/3 international equities, and 1/3 Treasury inflation protected securities. If you can make a Margarita, you can manage this portfolio--- and practicing is fun.

    Speaking at a recent Financial Planning Association conference, planning Guru Harold Evensky told planners his firm had decided to concentrate on instruments like ETFs. It was, he said, the only strategy that would work in the low return environment he is expecting. Only a small portion of client money would be invested in non-index funds.

    Evensky, I think, is on the leading edge of the advisory community. Rather than search for good stock pickers, he’s putting his energy into providing efficiently delivered market returns.

    With nearly 200 ETFs it’s easy to build a diversified portfolio. You can own large, mid, and small cap domestic indices. You can tilt toward growth or value. You can invest in markets as small as Belgium or Hong Kong. You can also invest in specific sectors such as energy, gold, real estate, or pharmaceuticals.

    The most interesting ETF development is the creation of “intelligent” portfolios. This second wave of indexing goes beyond building portfolios that simply reproduce a broad market index.  Instead, the index is constructed with rules that may produce superior performance. The Fundamental Index ETF, based on research by Rob Arnott  and soon to be launched by Powershares , back tests with a long term advantage over the S&P 500 Index of about 200 basis points a year.

    Most portfolio managers would kill or sell their souls for that kind of an edge.