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The Best ETF Funds to Buy — and the Dogs to Avoid

Exchange traded funds, or ETFs, continue to be a topic of conversation for both seasoned investors and newcomers alike. That’s probably because the landscape of these funds is staggering, diverse and growing all the time.

According to Morningstar, there are nearly 1,300 exchange-traded funds on the market today, 187 of which were introduced in 2011! You can bet that 2012 will continue that trend.

So it’s no surprise that Patrick wrote this note recently:

“I have always been a bit leery of ETFs, given the synthetic nature of the beasts and the opacity regarding their construction.  That being said I would be interested if you could point me toward a few which you feel are designed to perform as advertised, for trading purpose.”

There is certainly some murkiness around some kindy ETFs like 3X leveraged funds or ETNs (exchange traded notes) that deal in debt instruments rather than equities. Complicating matters are funds with under $100 million under management and low trading volume – the equivalent of penny stocks in fund form. I’ll admit that those ETFs are different “beasts” and it’s buyer beware. After all, double or triple ETFs like the Direxion Daily Financial  Bear 3X ETF (NYSE:FAZ) or the Direxion Daily Financial Bull 3X ETF (NYSE:FAS) never performs exactly three times their benchmark. (Please read the SEC’s in-depth explanation of leveraged and inverse funds for a great primer on the subject).

But don’t let some of these crazy ETFs turn you off all funds. There are some very respectable and established ETFs out there worth your time.

For starters, I am a huge believer in the Vanguard family of ETFs for the long term, since they are defined by rock-bottom costs and are pegged to major indexes. Check out this fact: the average expense ratios for Vanguard funds is 0.17%.

Some index funds like Vanguard Growth (NYSE:VUG) are even lower, at a paltry 0.12%. I will gladly pay that small fee for the built-in diversification and lack of a minimum buy-in.

I also like sector-based ETFs in the short term for focused plays on trends. The Financial Select Sector SPDR ETF (NYSE:XLF) financial ETF is great fodder for buying dips in banks and riding the momentum for a week or two — but as you saw this week, timing is everything. Another fun sector bet has been the iShares Dow Jones U.S. Utilities Sector Index Fund (NYSE:IDU) that surged in 2011 (though it might be hitting a wall soon). And of course you can’t overlook the short-term moves that the SPDR Gold Trust (NYSE:GLD).

You can, of course, trade just like these ETFs and save yourself the management fee. But if you’re looking for a short-term trade then the costs shouldn’t bee too much of a deterrent.

Consider the performance of the GLD gold fund. The ETF is off -12.8% from its August peak while gold prices are off 13.5% — not perfect correlation, but very close. Similarly, when gold ran up 44.8% in the first few months of 2011, the GLD gold fund ran up 38.8%. True that some profits were left on the table, but the small fee seems worth it considering a pure play on gold would involve a safe, a trip to a coin show or other logistical messes many investors prefer to do without.

Generally, I really like most of State Street’s ETFs (the SPDR funds like those mentioned here) as well as iShares funds for my sector plays. If you’re going long-term, however, it’s impossible to beat the low costs of Vanguard.

Just make sure to do your research into fees, and into the components of each fund before you buy. Like mutual funds, ETFs have to disclose their holdings — so check out a prospectus first before you just jump in to a sector bet.

Jeff Reeves is the editor of Write him at editor@investorplace??.com, follow him on Twitter via @JeffReevesIP and become a fan of InvestorPlace on Facebook. Jeff Reeves holds a position in Alcoa, but no other publicly traded stocks.

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