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There are a lot of ways to go hunting for the best equity funds, but using exchange traded funds may be the most practical approach for many investors, says David Fry of ETF Digest.

Gregg Early: I'm here with David Fry, publisher and editor of ETF Digest, and author of the new Amazon.com eBook, The Best ETFs: US Equities. David, I guess the question would be what advantages do you see with ETFs over buying US equities, just outright buying the stocks and creating a portfolio that way?

David Fry: I think for most people it's just much less risk for them to be spread out over an index versus trying to pick stocks. And then with stocks it becomes more difficult to pick the best ones, and how many do you need and so forth.

There's more risk obviously in stocks than there would be in an overall index that's weighted appropriately. That said, most returns this year have been with Apple (AAPL) because of its oversized weighting in many indexes. If you didn't own Apple, you probably didn't perform that well in 2012.

Gregg Early: Within the context of investing in the indexes, is there any way to-like you said, Apple appears on more than just the Nasdaq index and there are various tech indexes and things of that nature. So how does an investor weed through that? If they're looking for some strategic exposure, do they just buy a broad index like the Russell 2000, or should they accumulate ETFs that represent various industrial sectors? How do they begin?

David Fry: Well, what we have done is...in the eBook, for example, there are 600 US equity ETFs. That's a lot to choose from for people. So we have broken it down into the dozen sectors that comprise the US equity ETFs, and then have picked just a few within each sector that are representative enough of that sector in ETFs.

Now the No. 1 thing people have to remember is they need to separate their investment objectives from that of industry sponsors, because everybody wants to have...in the industry anyway, they have business interests and they want you to be involved in their ETF. You really have to separate yourself from them.

So what we've tried to do in the book is to do just that. Nobody is going to buy, of the 600 we have broken it down to around 70, but nobody is going to buy 70 ETFs. But three in each of the categories, whether it be financials or technology or biotechnology or dividends or so forth, will do the job for most people.

They can pick one or two from each of the categories we've selected that are representative of how the indexes overall perform and ETFs overall perform, because there really isn't that much difference one to another when they get really repetitive.

Gregg Early: You're looking to reflect a particular index in each of the sectors.

David Fry: We're interested in fees. We're interested in liquidity. We're interested in assets under management, and if there's any difference in style one to another with a similar index sector then we'll choose that one. But we really don't have to go down into a very deep area to pick something that's just not trading well or is just very repetitive and doesn't make a big difference.

Gregg Early: So liquidity is a big factor in what you're looking at. That gives the investor a way in and a way out without having to deal with spreads.

David Fry: That's right, and with good assets under management and liquidity you get better tracking of the underlying index, and that's important to people. Also fees are important, so we try to pay attention to that too...but sometimes a good index will outperform another just because. Fees make a difference, but they're not the only difference.

Gregg Early: Were there any surprises in running those screens? Did you end up with maybe a boutique firm here and there that popped into the No. 1 place, even though you had larger organizations with probably significantly more assets under management, and things of that nature?

David Fry: Right, so I'm obviously offending some issuers, but the point is really for investors to separate their interest from the issuers. When we went through the group, we could find maybe one or two or three within each sector.

For example, in financials there's 40 different ETFs available to track financials in that sector. People really need some help in figuring out which of those are most suitable to them and helpful to them, then building a portfolio maybe from the universe of equity sectors that are important to them, suit their objectives.

Gregg Early: Is there a particular sector that you could speak about and sort of talk about maybe a couple of the funds that you found in the particular sector? The entire process, walking it through for us.

David Fry: Well, the big thing right now of course for investors is our demographics. We see a lot of people gravitating towards dividends, and that's been the biggest area of growth of new issues, because frankly the US equity sector is pretty well saturated in terms of ETFs. We see a big move towards dividends.

Let's say we take the biggest and oldest, which is DVY, which is the Dow Jones dividend ETF. DVY was one of the first issued. With that particular focus, and with that said, if people are not in an IRA or 401(k) and they're retirees-which is where the big trust has been for the attraction of dividends-and now we approach the fiscal cliff, dividends may be taxed as ordinary income instead of the 15% that currently exists.

You see now there are over 70 companies, for example, that have just issued special dividends to take advantage of the 15% preference on dividends. There's going to be a problem coming up very soon with dividend issues if they lose that preference, unless of course the dividend sectors are in a tax-exempt account.

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Tickers Mentioned: Tickers: DVY, AAPL

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