The ETF 50 Index™ finished September ahead 4.7%, its largest monthly gain this year. The benchmark of the most widely held exchange-traded funds advanced 3.5% in the third quarter to finish the first nine months of the year ahead 11.5%.

Despite the spreading credit mess and the continuing weakness of small-cap stocks, investors are racking up solid and accelerating advances. ETF investors racked up gains of $17.20 billion in September, bringing their year-to-date profits (exclusive of new flows) to $48.54 billion.

And despite a flight from risk that began in August, September's biggest gainers included iShares Brazil Index (EWZ), up 19.5%, iShares FTSE/Xinhua China 50 Index (FXI), up 19.8%, and iShares Latin America 40 (ILF), ahead 13.8%. The more-diversified iShares Emerging Markets Index (EEM) advanced 11.6%.

SPDR S&P 500 (SPY) was ahead 3.4% in the month.

Reflecting inflation fears stoked by the Federal Reserve's half-point cut in interest rates during the month, StreetTracks Gold Shares (GLD) spurted 10.5% in September.

Among domestic stocks, the weakest groups were small caps, finance and value securities. iShares Russell 2000 Index (IWM) crawled ahead 1.5%, the Financial SPDR (XLF) 1.7% and iShares S&P Mid Cap 400 Barra Value (IJJ) 1.4%.

The ETF 50 Index™ posted its second-best 2007 performance in April with a gain of 3.4%. The biggest monthly decline was July's 1.8% slide.

The ETF 50 Index™ represents the asset-weighted price performance of the 50 largest exchange-traded funds. It consists of a broadly diversified universe of funds representing domestic and foreign stocks, bonds, commodities and real estate, and is a better indicator of actual investor returns than indices tied to particular markets.

Whether or not you're a new investor, ETFs are probably new to you. Nearly half of all of these streamlined, low-cost portfolios have been introduced this year. When the bear market started seven years ago there were 30 of them; since the bulls began running in 2003, their numbers have exploded to more than 550.

Many of us, therefore, are in the process of transitioning our portfolios to incorporate more ETFs in place of traditional mutual funds, or adding ETFs to our other holdings. Our reasons are many: to trim expenses; to consolidate in a single account investments that might be spread among numerous mutual fund families; to avoid the risk that our managers will change or falter. One ETF Insider subscriber dropped me a note recently as she addressed this issue:

Tim, I'm totally in a Vanguard IRA. I've been following Dan Wiener's conservative growth portfolio model, somewhat modified. (Doing good!) How do I go about switching some money to ETFs? B.G.

Dan, the editor of The Independent Adviser for Vanguard Investors (and a friend of mine), focuses primarily on actively managed mutual funds in his model portfolios because he knows that some of Vanguard's top managers are index-beaters. But he's a believer in ETFs, and I think he would agree with this advice--in fact, I've asked him, and incorporated his ideas here:

If you're a Vanguard investor, as B.G. is, then the first step is to exploit Vanguard's own family of ETFs, most of which are clones of their existing index mutual funds with the added benefit of exceptionally low expenses. For example, the short-term investment-grade bond mutual fund he recommends in his conservative growth portfolio has an ETF analog, Vanguard Short-Term Bond ETF (BSV). It isn't exactly the same, but it's a close match. Vanguard Emerging Markets mutual fund is available as Vanguard Emerging Markets ETF (VWO). Dan himself recommends the emerging markets ETF over the open-end fund because of the fund's 0.5% front-end and back-end loads. Those loads can cost you a lot more than most brokerage fees for buying the ETF will.

Anytime you're examining this kind of transition, first determine what benchmark the mutual fund you own compares itself with. You can find that out in fund literature, e.g., the fund's prospectus, or from an analysis service like Morningstar. Virtually without exception, those benchmarks are available as purebred ETFs. For example, if the actively managed fund's benchmark is the Russell 2000, a popular small-cap index, the corresponding ETF is iShares Russell 2000 Index (IWM). You may decide that the index route, using ETFs, is your preferred strategy.

Of course, when you make this kind of transition, you make a trade-off. ETFs are index funds, and some active mutual fund managers consistently beat their indexes. But mutual funds have overhead that ETFs don't, including the cash they have to hold in reserve, whether to meet redemptions or because they haven't put it to work yet. The typical mutual fund sets aside 5% of assets in this manner; with ETFs, 100 cents of every dollar are put to work. In a bull market, having all your dollars invested is an advantage. When the markets turn down, of course, that cash holding may help preserve capital a bit.

I own every ETF in the ETF Insider Model Portfolios , but I also own a number of mutual funds that I've had for years. (My personal retirement portfolio is so similar to the ETF Insider Growth Model Portfolio that the performance of the two has been identical in recent months.) Like our subscribers, I'm always on the lookout for ways to exploit ETFs to make my portfolio more fully diversified, efficient and economical to own. Techniques like these are part of the research I do to identify ETFs that contribute the most to my, and your, total portfolio satisfaction.

Recently I got this email from one of our subscribers:

Tim, what's the easiest way to withdraw funds from income that ETFs produce?--T.W.

I recommend these three rules to income investors of all stripes, whether they use stocks, mutual funds or ETFs:

1. Collect dividends as cash -- Never automatically reinvest dividends. (With ETFs, this is easy.)
2. Focus on total return, not yield -- Plan to draw half your income from distributions and the other half from the sale of ETF shares.
3. Sell shares on a schedule -- Time the sales to the middle of the month, the middle of the quarter, and not December.

Those are the guidelines; now let's talk about what each means for ETF investors.

Collecting dividends as cash

ETFs are very well suited to income investors. Unlike mutual funds, distributions cannot be automatically reinvested, so they go directly into your cash account. (Some brokerages offer a dividend reinvestment plan that can then automatically reinvest them for you.) And whereas mutual funds are required to distribute taxable capital gains to their shareholders, ETFs can be managed so such gains are avoided. PowerShares, for example, has never made a cap-gains distribution on any of its funds.

This tax-friendly characteristic minimizes the possibility you'll buy a fund immediately ahead of a big distribution, which would cause you to owe taxes on what amounts to a return of your capital. That is, even though the value of your investment hasn't changed from just before the distribution to just after it, you still owe taxes on the gains the fund made during the year before you bought the shares.

So the nature of ETFs means that income distributions, from interest and dividends, arrive as often as monthly. Let's use Vanguard Total Bond Market ETF (BND) as an example. Somewhere between the fifth and the 10th of each month, this fund has paid distributions around 25 cents to 30 cents a share, which works out to an annual yield of 5.12%. iShares iBoxx $ Investment Grade Corporate Bond Fund (LQD) is yielding 5.63%, paying out monthly dividends recently of between 45 cents and 50 cents a share on a schedule similar to that of the Vanguard fund.

Even many equity ETFs have significant yields. iShares MSCI EAFE Index Fund (EFA) distributes dividend income annually in December; last year the distribution was $1.53346. (ETFs typically pay distributions in fractions of pennies. Most stocks and mutual funds do not.) That's equal to a yield of 1.84%, based on its recent share price. Vanguard Large Cap ETF (VV) yields 1.73% and pays quarterly.

Generally speaking, the record, ex-dividend and pay dates of income ETFs fall within a total period of five to seven days. For example, Vanguard Total Bond began trading ex-dividend on Oct. 1 to shareholders of record Oct. 3, and paid the distribution on Oct. 5.

There is one big exception to this rule: SPRD S&P 500 Trust (SPY), the most widely held ETF of all. It yields 1.77% and also pays quarterly. The next distribution will be $0.7187, paid on Oct. 31. But the ex-dividend date on those shares was Sept. 21. So planning an income stream from this fund is a bit of a headache. Fortunately, it's not one of our Model Portfolio holdings.

Focus on total return, not yield

My ETF Insider Model Income Portfolio is designed for an investor who takes the first 5% of its total return each year as income and leaves the balance of at least several percentage points to continue growing. Of this 5% return, about half comes from distributions. The other half comes from regular sales of ETF shares to make up the difference. On a $100,000 portfolio, that means distributions in the course of a year of $2,500 and the sale of $2,500 worth of ETF shares--perhaps 50 shares of ETFs with average prices of $50.

To return to our example of iShares MSCI EAFE Index Fund, it generated average total returns of 23.3% in each of the five years ended Sept. 30, 2007. That makes it a likely candidate to be trimmed from time to time to keep it in line with an asset-allocation target of 15%.

When to sell shares

I recommend timing sales of fund shares so they don't fall close to ex-dividend dates, which means the middle of the month for ETFs that make monthly distributions, the middle of the quarter for most equity ETFs, and November or January for funds that make one distribution in December.

Alternative approaches: fixed income vs. inflation

The alternative to my approach to income investing is to seek higher yields, and many retirees have substantially all of their investments in bonds for this reason. That creates, however, the dreaded fixed income. Expenses are not fixed; from property taxes to gas for the car, they go up and up.

My approach has inflation protection built in, because total returns are greater than income requirements, and your kitty--and your income stream--is constantly growing. Twenty years into retirement this approach provides twice the cash it did at the start, and at least the same amount of purchasing power. By contrast, a bond portfolio will be providing a steady stream of cash that's worth half as much then as it is now.

Income investing is really risky when you don't take any investment risk. The risk of inflation can't be avoided.

ETF investors racked up average gains of 3.8% in October, greatly outperforming the broad domestic stock market. But U.S. technology stocks did make a statement, with PowerShares QQQ (QQQQ) shooting up 7.0% in what is usually a strong season for that sector.

SPDR S&P 500 Trust (SPY) advanced only 1.4% in the month, greatly eclipsed by the 4.3% return of iShares MSCI EAFE Index (EFA), the corresponding benchmark for foreign equities. Vanguard Emerging Markets ETF (VWO) shot up 13.0%, propelled upwards in particular by soaring markets in China and Brazil.

Foreign bourses continue to greatly outperform the domestic market, owing both to their own strength and to the continuing weakness of the U.S. dollar. The only significant loser in October was the financial SPDR, which shed 2.0% of its value as the credit crisis continues to search for a bottom.

iShares Brazil Index (EWZ) spurted 16.4% in October, and iShares FTSE/Xinhua China 50 Index (FXI) ballooned 21.4%.

The weaker dollar, and inflation fears, found expression in the 7.0% boost in the price of StreetTracks Gold Shares (GLD), which tracks the metal's spot price.

The ETF 50 Index advanced 9.5% in the last three months and is ahead 15.8% so far this year. SPDR S&P 500 is up 6.1% in the three months and 9.2% year-to-date.

October's performance was second this year only to September's 4.7% gain.

The ETF 50 Index™ represents the asset-weighted price-only performance of the 50 largest exchange-traded funds, which account for 76.8% of total ETF assets. The index consists of a broadly diversified universe of funds representing domestic and foreign stocks, bonds, commodities and real estate, and is a better indicator of actual investor returns than indices tied to particular markets.