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How investors can dive into ETF pool — without drowning

If the last few years are any indication of what lies ahead, the ranks of investors diving into exchange-traded funds for the first time will continue to swell this year.

For those pondering such a move, there are many ways to go about it and some traps to avoid.

"There are always investors jumping into this pool for the first time," said Ben Johnson, director of global ETF research at Morningstar. "Part of the growth in the ETF marketplace can be attributed to just that."

Dollars and stocks
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Like mutual funds, ETFs hold baskets of assets, such as stocks, commodities or bonds. But like common stocks, they trade over an exchange throughout the day.

The number of ETFs has surged in recent years, thanks to the growing popularity of the funds, whose oft-touted benefits generally include low management fees (or operating expense ratios), liquidity and transparency with regard to current holdings. As of January, there were nearly 1,900 ETFs, with some $2 trillion in assets under management, up from $1.3 billion at the end of 2012.

For many investors, ETFs represent a way to fill holes in a diversified portfolio or to bet on battered asset classes, sectors or markets that they believe have upside, rather than picking corresponding individual stocks or bonds.

The Energy Select Sector SPDR, for instance, might appeal to investors who want to wager on a rebound in oil prices. The fund, among the 100 largest ETFs, tracks the Energy Sector Index, comprised of energy and energy-related stocks in the S&P 500 index.

For the average investor, such bets should be very limited in scope, confined to no more than, say, 10 percent to 20 percent of a diversified portfolio, said Michael Iachini, managing director of mutual fund and ETF research at Charles Schwab Investment Advisory.

"This concept of idea investing is one of the main ways that many investors get started with ETFs," he added. "They may believe that the energy sector is going to bounce back or that China is oversold, and they use an ETF to act on that idea."

Top 5 ETFs

NAME
TICKER
MORNINGSTAR CATEGORY
NET ASSETS 2/26/16 ($B)
SPDR S&P 500 ETF SPY US ETF Large Blend 171.7
iShares Core S&P 500 IVV US ETF Large Blend 66.1
iShares MSCI EAFE EFA US ETF Foreign Large Blend 54.8
Vanguard Total Stock Market ETF VTI US ETF Large Blend 54.7
Vanguard 500 ETF VOO US ETF Large Blend 40.5
Morningstar, Inc.

While ETFs were commonly used as single-stock substitutes when they first gained popularity, they now occupy a place at the core of many investors' portfolios, according to Johnson of Morningstar. In fact, many investors now use ETFs exclusively, he said.

There are various types of ETFs, but the top 100 of them, as measured by assets under management, are index funds that track broad, market-cap weighted benchmarks, such as the S&P 500 and the Barclays U.S. Aggregate Bond index.

At the end of 2015, these funds held three-quarters of the total assets in the ETF universe. That can be attributed in large part to the growing popularity of low-cost index funds, as opposed to funds whose managers actively engage in asset selection in an attempt to beat a market benchmark.

The average fee charged by index-tracking U.S. large-cap ETFs is less than a half percentage point, versus an average fee of nearly 1.2 percent for actively managed U.S. large-cap stock funds, according to Morningstar.

"The common theme among the top 100 ETFs is that they are every bit as boring as watching paint dry and grass grow at the same time," said Morningstar's Johnson. "They have ridiculously low fees and are a very good bet for a wide swath of investors.

"If there is one thing we know, [it] is that fees matter and are probably the only reliable predictor of future performance."

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ETF-only portfolios can be very simple or complex, depending on the number of funds used and their strategies. If it's simplicity you crave, one option is a broadly diversified portfolio of index funds built from just two ETFs, a total world stock market ETF and a total bond market ETF, according to Iachini at Charles Schwab.

With this type of portfolio, it should be easy to determine when you need to rebalance to maintain your asset-allocation targets. A two-ETF portfolio can also help investors keep a lid on trading costs, said Iachini.

The trading costs associated with ETFs, which can include brokerage commissions, may negate the benefits of their low management fees for investors who regularly deploy small amounts of money — although most large brokerage firms have ETF platforms that allow clients to trade commission-free.

"The place to start is: 'What should my portfolio look like?' How much do you want in stocks vs. bonds, domestic vs. international [and] large-cap vs. small-cap equities." -Larry Swedroe, director of research for The BAM Alliance

Another factor to consider is the trading costs associated with ETFs that have wide bid-ask spreads.

Simply put, a bid-ask spread is the difference between the lowest price at which a trader is willing to sell an ETF share (the ask) and the highest price a buyer is willing to pay (the bid). Smaller, thinly traded ETFs may have wide bid-ask spreads, dragging down returns for investors who trade frequently.

"If you are a small do-it-yourself investor, you might be better off sticking with low-cost mutual funds" because of the trading costs associated with ETFs, said Larry Swedroe, director of research for The BAM Alliance of financial advisory firms.

Thanks to the growing menu of ETFs, investors can slice and dice the market in many ways, building, for instance, a fine-tuned portfolio with dozens of index-tracking ETFs that offer exposure to all manner of stocks, bonds, commodities and real estate equities. The disadvantages of such a portfolio include complexity and potentially high trading costs, according to Iachini of Charles Schwab.

Swedroe stresses that investors ought not put the cart before the horse when it comes to jumping on the ETF bandwagon. Their first order of business, he said, should be coming up with an investment plan based on individual risk tolerance and financial goals.

"The place to start is: 'What should my portfolio look like?'" Swedroe said. "How much do you want in stocks vs. bonds, domestic vs. international, large-cap vs. small-cap equities" and so forth, he added.

Once you've come up with a written plan and an investment policy statement, which should include an asset-allocation strategy, "then, and only then, should you decide on using mutual funds vs. ETFs to get exposure to the asset classes" you desire, Swedroe said.

— By Anna Robaton, special to CNBC.com