Lynn O'Shaughnessy

Who would ever think of spreading caviar on a hot dog? Or dropping a Rolls-Royce engine into a Toyota Corolla? Of course, this isn't remotely practical, but these sorts of upgrades - if you can call them that - are making inroads into the world of index investing, the plainest Jane of investment strategies.

Today, for instance, you can invest in a curious index that tracks 30 American food and beverage companies. You can now binge on saturated fat and invest in it, too. You can also index your way through the Rand McNally Atlas by dabbling in the stock markets of countries you'd never want to visit.

One reason why investors can wander easily down some of Wall Street's more curious back alleys is because of the emergence and popularity of exchange-traded funds. These funds can be invaluable investment tools, but if you hang out with the wrong ones or use them in inappropriate situations, your portfolio could get hijacked.

An exchange-traded fund looks and behaves very much like an index mutual fund. You could say that one's a Labrador retriever, and the other's a golden retriever. Like an index fund, an ETF holds stocks or bonds in its portfolio that replicate its underlying benchmark. An investor in the Vanguard 500 Index Fund, the nation's most popular index fund, owns shares in the 500 blue chips in the Standard & Poor's 500 Index. You'd own the identical stocks if you invested in two popular exchange-traded funds - iShares S&P 500 Index or the Standard & Poor's Depository Receipts Trust, which most people call by its abbreviation - SPDR (pronounced spider). The point of ETFs and index mutual funds is, of course, to capture the market average of whatever you want to invest in, whether that's stocks or bonds. If you index by either method, you should fare better than the vast majority of investors.

One of the most endearing traits of the exchange-traded fund is its frugality. Investing in ETFs is the equivalent of pushing a shopping cart down the aisles of a 99-cent store. Exchange-traded funds are priced far more reasonably than the average actively managed mutual fund. The annual expense ratios for ETFs dip as low as .07 percent. In contrast, the average actively managed mutual fund sports an expense ratio of roughly 1.4 percent. The pricing difference might seem like a big so-what, but it can mean the difference between retiring with seven figures versus six.

Lynn O'Shaughnessy

Lynn O'Shaughnessy is the author of Retirement Bible.

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