A new Wall Street darling

Exchange-traded funds have multiplied in number—and evolved into one of the hottest investments on Wall Street. Here's why.

By Leslie Kane
Senior Editor

Exchange-traded funds (ETFs) have become smash hits since their debut in 1993: Assets in them grew from $464 million that year to $85.9 billion in April 2002. "ETFs have been among the fastest-growing investment vehicles," says Lee Kranefuss, CEO of Barclay's Global Investors Individual Investors Group in San Francisco. "Investors like them because they contain the best features of both stocks and mutual funds."

Like index mutual funds, ETFs closely track the performance of a specific market index, and their holdings generally change only when the index itself changes. But like stocks, ETFs trade on an exchange—usually the American Stock Exchange. You don't buy them from and sell them back to the issuing company, as you do a mutual fund. For busy, long-term investors who want well-diversified, cost-effective portfolios without having to choose individual securities, ETFs can make a lot of sense.

Among the most popular ETFs is Qubes, the nickname for the Nasdaq 100 Index Tracking Stock. Some other popular ones include Vanguard's Total Stock Market VIPERs and Standard and Poor's Depositary Receipts—SPDRs. VIPERs tracks the Wilshire 5000 Index, and SPDRs tracks the S&P 500.

But with these market indexes—and most others—down, why would you want to invest in ETFs now, you may wonder? To get the best prices, investment advisers reply. That way, you'll take full advantage of the eventual recovery.

ETFs offer several distinct advantages over traditional index funds:

Tax savings. "ETFs are substantially more tax efficient than mutual funds tracking the same index," says James V. Kelly, chairman of Addison Capital Management in Philadelphia.

For instance, if you'd invested $10,000 in an SPDR five years ago, by now you'd be $809 richer than if you'd invested the same amount in the Wells Fargo Equity Index (assuming your profits are taxed at the long-term capital gains rate of 20 percent).

Mostly, the bigger tax bite on the Wells Fargo fund comes from capital gains distributions, which mutual funds make annually if they've had capital gains that year. Whenever a fund manager sells a stock at a profit, the capital gains mount. Since there's less trading in index funds, they generally make smaller capital distributions than actively managed mutual funds. But ETFs' capital distributions are even more modest.

Even if you hold ETFs in a tax-deferred account, you benefit. "In a mutual fund, when shareholders sell, the manager often has to sell stocks to meet investor cash redemptions," says Kelly. "He would likely choose stocks with a high cost basis [originally purchased at a high price] in order to limit the tax impact for shareholders with taxable accounts. However, if he didn't have to worry about taxes, he might have sold other stocks. So the portfolio's overall performance could be affected by the manager's decisions about which stocks to sell.

"With ETFs, because of the special way they're structured, the same situation could be handled with an in-kind transfer that would have no tax impact on the remaining shareholders," says Kelly. "The manager just swaps one group of stocks from the underlying index with another group." Adds Kranefuss: "Shareholders find buyers and sellers through the stock exchanges, so investors aren't penalized with tax consequences when other shareholders sell."

Greater control over price. ETFs are priced continually throughout the day, much like stocks are. So when you buy or sell an ETF, you get a more current price than you do with a mutual fund, which is priced only at the end of the day.

Say, for example, you see the Dow shooting up at 11 a.m. and place an order to sell some mutual fund shares. At 3 p.m. the market plunges, and by end of day, the price you received for your mutual fund shares is much lower than you expected.

Lower expenses. The average expense ratio for ETFs is just 0.48 percent, compared with 0.75 percent for index mutual funds and 1.54 percent for actively managed funds. (Some index funds' expenses are as low as those of ETFs, however.)

Trading benefits. Because ETFs trade on an exchange, you can sell them short or trade them on margin, which you can't do with mutual funds.

As with stocks, you can trade most ETFs in any size lots, through a brokerage. Of course, that means you'll also pay a commission when you buy or sell them, and that's one drawback of ETFs. Buying through an online discount broker can cut those commissions, but you could avoid them altogether by buying a similar no-load index fund directly from the fund family.

The biggest limitation of ETFs, however, is that like index funds, they offer you no opportunity to outperform the markets; they can only duplicate the performance of the indexes they track. If that idea gives you indigestion, then ETFs should play no role in your portfolio.

On the other hand, if knowing that you won't underperform the markets is a comfort, ETFs might be a perfect addition to your portfolio. You can even construct a fully diversified low-cost portfolio composed entirely of ETFs, if you'd like. You might choose ETFs that track the S&P 500 (large-caps), the Russell 2000 Index (small-caps), the MSCI-EAFE Index (which includes companies in Europe, Australia, and the Far East), and one of the Lehman Brothers bond indexes. For a more diverse portfolio, you could also select the Nasdaq 100 Index ETF or a sector ETF.

Or you could strike a compromise—consider using ETFs as your core holdings, for instance. "You could keep the majority of your assets in ETFs," suggests Kranefuss. "Then, select a small number of mutual funds that have active managers. You'll have a low-cost, diversified portfolio and opportunities to beat the indexes."

ETFs that can charge up your portfolio

You can choose from about 120 exchange-traded funds that track a variety of equity and bond indexes. For example, Barclays Global Investors puts out 81 ETFs called iShares, three of which track foreign indexes. Other iShares cover the US equity markets by size, style, and sectors, such as the Dow Jones US Healthcare Sector Index or the Dow Jones US Real Estate Index. Four iShares track Lehman Brothers bond indexes.

Merrill Lynch’s HOLDRS don’t track particular indexes but do focus on a theme, such as biotech or Internet stocks.

ETF

What it tracks

Issuing company

Number of ETFs

DIAMONDS
Trust Series I

Dow Jones
Industrial Average

State Street Global Advisors

HOLDRS

Varies

Merrill Lynch

iShares

Varies

Barclays Global Fund Advisors

Nasdaq 100 Index Tracking Stock (Qubes)

Nasdaq 100 Index

The Bank of New York

SPDRs;
StreetTRACKS

S&P 500 varies

State Street Global Advisors

VIPERs

S&P 500; Wilshire 4500 Completion Index; Wilshire 5000 Total Market Index

The Vanguard Group

 

Leslie Kane. A new Wall Street darling. Medical Economics 2002;22:50.