Exchange-traded funds offer a way to diversify a portfolio beyond what’s available in a company 401(k) plan

John Spence

Updated March 2, 2009 12:01 a.m. ET

Looking for a more varied investment diet than your 401(k) plan’s menu can provide?

ENLARGE

Alison Seiffer

But those aren’t options in many company plans. Many investors are handcuffed by limited choices in their 401(k) plans, says Matt McCall, president of investment adviser Penn Financial Group LLC in Ridgewood, N.J. They need to look elsewhere for alternatives.

That doesn’t mean, of course, that ETFs will always be the right choice. Some, for instance, are more expensive than certain mutual funds when all fees are considered, and active trading of ETFs can be costly. In other cases, a given mutual fund might simply be a better fit for an investor’s portfolio. But there are ETFs available to suit a wide range of investment goals.

ETF Inflows

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At the end of 2008, there were 728 ETFs holding $531.3 billion in total assets, according to the Investment Company Institute, the main trade group for the mutual-fund business. Although overall assets have shrunk during the financial markets’ swoon, ETFs had net inflows of $177.2 billion last year, while stock mutual funds had net outflows of $234.3 billion, according to the institute.

The ability to trade ETFs all day on an exchange has made them especially attractive in the current financial-markets crisis, with prices sometimes fluctuating wildly within a single day. So has their transparency — ETFs disclose their holdings daily. And amid the market wreckage, many investors are playing it safe by turning to relatively low-cost, index-tracking investments, like most ETFs, rather than trusting more-expensive, actively managed mutual funds to outperform the markets.

Also, some ETFs give investors the ability to hedge their portfolios, notes Tom Anderson, head of strategy and research in the intermediary business group at State Street Global Advisors, a unit of State Street Corp. and a major ETF sponsor. These so-called inverse ETFs are designed to deliver the opposite of a market benchmark’s performance. So, for instance, an inverse ETF that moves counter to an index of overseas stocks could help limit the damage to a portfolio with significant investments in declining foreign shares.

Mr. Anderson notes that ETFs also have tax advantages that have come into play in the markets’ steep slide. When mutual funds face heavy redemptions by investors, as they have in recent months, they have to sell some of their holdings to pay the investors who are pulling out. In some cases, they have had to sell assets they’ve held for a long time, so they’ve registered capital gains on those sales. And those capital gains have to be distributed among the mutual funds’ investors, who may be hit with a tax bill as a result. By contrast, investors who want out of an ETF sell their shares to other investors on an exchange, realizing their own capital gains or losses. In most cases, there’s no need for the fund to sell assets to cover redemptions, so no capital gains are generated for the shareholders who remain in the ETF.

Gold ETF Glitters

Underscoring the fear in financial markets and worries over the U.S. dollar, SPDR Gold Shares passed several key milestones in February as investors piled into the perceived safety of the precious metal. In late February the fund exceeded $30 billion in assets, making it the second-largest ETF. Also in February, the amount of gold held by the fund surpassed 1,000 metric tons for the first time.

ENLARGE

The gold ETF is down slightly over the past year, but up more than 18% a year on average over the past three years, according to Morningstar. Investors can also play the gold angle with ETFs that invest in mining stocks, such as Market Vectors Gold Miners ETF.

Other ETFs give investors exposure to individual commodities or to a range of commodities. Besides their value in diversifying a portfolio of stocks and bonds, commodities are considered by market analysts to be a hedge against inflation.

PowerShares DB Commodity Index Tracking Fund, with assets of $1.3 billion, is one ETF that tracks a broad basket of commodities. U.S. Oil Fund, which has $3.5 billion in assets, follows an index of crude-oil futures. Energy Select Sector SPDR Fund is a $4 billion ETF tied to an index of energy stocks. All three funds staged sharp rallies in the first half of 2008 but have fallen hard since commodities prices peaked over the summer.

The performance of ETFs that invest in metals and commodities is linked directly to the prices of the physical materials or related futures contracts. That’s different from funds that invest in the stocks of mining and natural-resources companies. Mining and energy stocks are seen as a leveraged bet on commodities, because the shares tend to be more volatile than the related commodity prices. Investors in these funds also are exposed to all the corporate risks that accompany stocks.

Real estate is another common form of diversification that’s often unavailable in retirement plans. Real-estate ETFs include SPDR Dow Jones Wilshire REIT ETF and iShares Dow Jones U.S. Real Estate Index Fund.

Tax Treatment

A word of warning: When venturing outside a 401(k), investors should consider the tax implications of the funds they buy. True, ETFs aren’t forced to sell assets to cover redemptions and then distribute any capital gains to investors, as mutual funds sometimes are. But investors still are subject to capital-gains taxes on ETF holdings they sell, and those tax rates aren’t the same for all types of investments. For instance, says IndexUniverse.com editor Matt Hougan, some capital gains from commodities ETFs that buy futures can be taxed at a higher rate than gains from stocks.

Also, commodities funds never take delivery of a commodity, but instead regularly roll their holdings of futures contracts — selling contracts that are near expiration and replacing them with contracts that expire later. If the new contracts are more expensive than the ones being replaced, the ETF can lose money on the swap, eating into any overall gains. So investors shouldn’t expect a fund to deliver the same gains they might see in the spot price of the underlying commodity.

Ideally, investors should put their holdings of the least tax-efficient funds, like those that invest in currencies or commodities, in tax-deferred accounts whenever possible, keeping stock funds in taxable accounts if necessary, Mr. Hougan says. For instance, an individual retirement account is a good place to stash a commodity ETF.

Of course, any time you put money in a taxable account when you haven’t maxed out your 401(k) contributions, you’re sacrificing tax deferral.

Investors who buy ETFs or any other assets outside a 401(k) also need to keep in mind that they’re complicating their overall portfolio. That means they’ll have to keep a closer watch to make sure the allocations of various assets don’t get too far out of whack due to market moves — like a surge in gold prices and a drop in stocks that bumps a gold ETF up to a higher percentage of the portfolio than desired.

Mr. Spence is a reporter in Boston for MarketWatch. He can be reached at jspence@marketwatch.com .