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ETFs are altering the investment landscape

Investors who purchase exchange-traded funds own a share of a portfolio of securities. But unlike mutual funds, ETFs trade like stock.

By HELEN HUNTLEY, Times Staff Writer

© St. Petersburg Times
published February 17, 2002


A decade ago, exchange-traded funds didn't exist. Even now they are barely a blip on the investment landscape. But ETFs, as they are known, pack the potential to revolutionize mutual fund investing.

Never heard of them? You aren't alone. Although there are now 102 ETFs with $83-billion in assets, they are dwarfed by the more than 8,000 traditional mutual funds and their $7-trillion in assets.

Fundamentally, ETFs are mutual funds. Investors who buy them own a share of a portfolio of securities. The two most popular, nicknamed "Spiders" and "Cubes," are index funds that track the Standard & Poor's 500 Index and the Nasdaq 100 Index, respectively.

But unlike traditional mutual funds, ETF shares are not purchased from or redeemed by their sponsoring fund companies. Instead, once they have been created, they trade like shares of stock and have to be purchased through a brokerage firm or financial adviser. Traditional mutual funds are priced once a day, after the market closes. The prices of ETF shares fluctuate throughout the day.

It's the fundamental difference in how ETF shares are bought and sold that intrigues investors and fund companies. The Vanguard Group, one of the largest traditional fund companies, now sponsors two ETFs and expects to have a menu of 20 or so available by year-end.

ETFs "have changed the investment management landscape," said Heather Locus, a Chicago area investment adviser who spoke last week at the "World Series of Exchange Traded Funds," a seminar that drew about 200 financial professionals to St. Pete Beach. She said her company, Balasa Dinverno Foltz & Hoffman, now uses ETFs for half of its new clients' equity investments.

Their advantages:

They are cheap. ETFs carry annual expense charges considerably less than those of typical stock mutual funds. One reason is that fund companies aren't shouldering the expenses of marketing the funds and processing shareholder purchases and redemptions.

They are tax-efficient. ETFs have minimal capital gains distributions.

They are transparent. Managers are required to publish their holdings daily.

They are easy to trade. ETFs provide a quick way in or out of the stock market and can even be sold short by those who want to bet that the market goes down.

But they are can be tricky. There can be a discrepancy between the trading price of an ETF and the value of the underlying securities, which may work for or against the investor.

The biggest drawback of ETFs is that investors must pay a brokerage commission every time they buy or sell, which makes the funds expensive for those accumulating shares in small amounts, such as participants in 401(k) plans. Tampa money manager Sameer Shah says he considers $10,000 the minimum investment to justify paying a brokerage commission.

e So far ETFs have proved to be most popular with short-term investors, such as traders betting on the Nasdaq's ups and downs or pension funds looking for a temporary parking place for money.

The funds attracted Vanguard's interest as a way to keep active traders out of its traditional funds, said Gus Sauter, who heads Vanguard's group of index funds. In a traditional fund, big cash inflows or outflows create headaches for the manager who must buy or sell securities.

With ETFs, "the fund manager doesn't have to jump through hoops to keep the fund in balance," Sauter said.

While ETFs could siphon assets away from traditional funds, Sauter said that hasn't been the case for Vanguard. Instead, Vanguard's ETFs, known as VIPERs, are opening up new markets for the company.

Because Vanguard doesn't pay commissions to brokers, most brokers don't offer traditional Vanguard funds to their clients. But brokers earn their regular commission on stock sales when they sell VIPERs or any other ETFs. In addition, foreign investors, who are prohibited from buying traditional U.S. mutual funds, can buy ETFs.

ETFs also happen to be a good fit with the way many investment advisers approach managing their clients' money. An ETF is an easy way to execute a strategy that calls for investing a specific percentage of a client's assets in a category such as large company stocks or midsize company stocks. ETFs also are popular with those who go for a "core plus" or "core/satellite" strategy. Someone following that approach would put most of a client's money in a few core ETFs tracking broad market indexes, with smaller amounts in individual stocks or actively managed funds. ETFs also can be used as a substitute for stock index futures.

Tampa money manager Shah said a combination of investments -- individual stocks, ETFs and traditional mutual funds -- often delivers the best return when taxes are taken into consideration.

While the most popular ETFs track broadly based stock indexes, there also are ETFs narrowly focused on indexes for specific sectors such as energy, technology, financial services and real estate investment trusts. There are even two based on Fortune magazine lists: one for the Fortune 500, the other for 50 companies with ties to the Internet.

Bond ETFs are being developed and some companies are lobbying the Securities and Exchange Commission to allow actively managed funds to trade as ETFs. One issue is whether active managers, who are selecting stocks rather than following an index, should have to disclose their holdings daily.

Although ETFs offer a lot of advantages, the investors who have been using them so far don't appear to be reaping the benefits, St. Petersburg money manager Robert Doyle said. While the typical mutual fund investor holds shares for three years, many ETF buyers trade in and out of the funds in a matter of days.

"The tax efficiencies and the benefits of the low-cost structure are being absorbed by the increased trading costs," he said.

-- Helen Huntley can be reached at huntley@sptimes.com or (727) 893-8230.

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