The Ins and Outs of ETFs

by Marla Brill
Publisher, Brill’s Mutual Funds Interactive

Mutual funds, unlike politicians, usually don’t like to air their differences with competitors in public. So it came as something of a surprise last August when fund giant Vanguard issued a pointed media “fact sheet” on exchange-traded funds, or ETFs, which sought to explode some of what it considers the myths surrounding this not new investment.

ETFs -- which some believe pose a serious threat to the mutual fund industry --  look like a mutual fund, but trade like a stock.  Each exchange-traded fund share represents ownership of an underlying portfolio of securities. Like a traditional index mutual fund, most are passively managed and seek to replicate an index or asset class. You can buy any one of the 79 available ETFs on the market today, including those that replicate the S&P 500 Index, the Dow Jones Industrial Average, or the tech-heavy NASDAQ 100. Although most trading activity centers around the larger, best-known indexes, the newer ETFs are based on sector plays ranging from Internet infrastructure to emerging foreign markets.

ETFs differ from traditional mutual funds because they trade on an exchange just like a stock. While index funds are re-priced at the end of the day at their net asset value, exchange-traded funds are priced throughout the day, and can be bought or sold almost instantly at the market price. You can sell ETFs short, or buy them on margin.

While those kinds of advantages probably lure more traders and speculators than long-term investors, exchange-traded funds have two main characteristics that make them appealing to the buy-and-hold crowd. Because of their unique operating structure, they offer greater potential for tax efficiency than a mutual fund. And, they often have lower operating expenses.

“An exchange-traded fund is the perfect marriage of two investment vehicles because you get the trading flexibility and low cost of a stock , with the built-in diversification of a mutual fund,” says Lee Kranefuss, CEO, Individual Investor Business, Barclays Global Investors. “Until recently, investors seeking a broadly diversified portfolio of index funds had to go to a number of different fund families. Now, they can build such a portfolio much more easily.”

Investors have apparently warmed up to the advantages of exchange-traded products. From 1998 to 2000, assets under management in ETFs more that tripled, and they now account for over $56 billion. With all this popularity, some press reports have declared the eventual demise of the traditional open-end mutual fund.

Even Vanguard, the company that brought index mutual funds to the masses, announced the creation of VIPERs (Vanguard Index Participation Equity Receipts), the ETF version of it own index funds, early last summer. The firm says the product should help divert active traders from its traditional index funds. 

A Small Bandwagon

So why, with its own product in the works, has Vanguard decided to issue an ETF reality check with its fact sheet?  Regardless of the firm’s motivation, the points outlined in its fact sheet seem to boil down to this: While ETFs are good for some people, they aren’t the best alternative for everyone. Traditional index mutual funds are often a better choice. 

Vanguard isn’t the only one trying to send that message. Some financial advisors who work with traditional index mutual funds aren’t stepping up to he ETF plate just yet, or are dabbling with them in a tentative, experimental way until they know more about the product.

“It is certainly possible that some exchange-traded funds will be more tax-efficient than index funds,” says Larry Swedroe, a St. Louis financial advisor who specializes in index mutual funds.  “Right now we’re taking a wait and see attitude. My impression is that they’re generally favored by active traders, and we don’t fall into that category.”

Richard Ferri, a financial advisor in Troy, Michigan, takes a similar view. “I have not used ETFs extensively in my business,”  he says. “Since most of my clients are buy and hold investors, ETFs seem to have very little advantage over traditional index funds from Vanguard and others. They seem to be for traders and hedgers, and open-end funds seem to be more for long-term investors.”

Barclay’s Kranefuss says that the view that ETFs are only for very active traders is a misconception. “When you look at trading activity on the larger ETFs, the average holding period is something like 20 to 30 days,” he says. “But the ten largest traders account for 80 percent to 90 percent of that volume.  Individuals and private investors tend to use these shares for long-term strategies.” 

If you feel like you’ve been left out of the ETF party, you shouldn’t. While exchange traded funds have grown rapidly over the last few years, that growth has been concentrated among a relative handful of shares, and among institutional investors rather than individuals or financial advisors. At $24.7 billion, the SPDR 500 (Standard & Poor’s Depositary Receipt, nicknamed “Spider”) is the largest exchange-traded fund in terms of assets, according to Wiesenberger, Thomson Financial.  Clocking in second is the NASDAQ 100 Tracking Stock with over $18.2 billion.  Together, the two exchange-traded funds account for over 75 percent of total ETF assets, and institutional investors account for 70 percent of the money invested in these stocks. 

Next: How ETFs work. Are they good investments?