Asset Allocation

• Proper asset allocation is essential to building a well balanced and diversified portfolio. Having some money in stocks, some in bonds and some in commodities and precious metals helps you spread out your risk and make the most of the money you have invested. You can find ETFs in all of these categories, and use them to create a diversified portfolio, with or without the use of traditional mutual funds.
  
  

ETFs vs. Mutual Funds

• You could conceivably replace all of the mutual funds in your portfolio with ETFs, but it might be wiser to use both traditional mutual funds and ETFs to round out your investments. An ETF that tracks a major index can be a good replacement for an index mutual fund, but it can be harder to replicate a quality managed fund by using an ETF. Look at your mutual fund holdings and see which funds can easily be replaced by ETFs and which cannot.
  
  

Commission-free Trades

• A number of brokerage firms and mutual fund companies now offer commission-free trades on certain ETFs. If you plan to make ETFs a core part of your portfolio, seek out firms that allow you to buy and sell without paying a commission. Commission-free trading allows you to invest a little bit at a time in the ETF of your choice, and allows you to reinvest any dividends or capital gains generated by the fund into additional shares without incurring any extra expenses.
  
  

Taxable vs. Tax Deferred

• You can buy and sell ETFs within either a taxable or a tax-deferred account, but it is important to look at the tax implications carefully. If you trade ETFs within a taxable account, you are subject to capital gains taxes on any profit you make. If you held the ETF for less than a year, you must pay a capital gains tax equal to your regular tax rate, which could be as high as 35 percent in 2011. If you plan to be an active trader of ETFs, it might be better to do that trading within a tax-deferred account like an IRA, and use your taxable accounts to hold a variety of low-cost mutual funds.