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When investment newsletter editor Doug Fabian discovered some of his favorite mutual funds had started imposing redemption fees on short-term traders, he hit the roof. Mutual funds, he declared, "are now in danger of going the way of the horse and buggy and typewriter." Their replacement: exchange-traded funds, popularly known as ETFs.
ETFs look a lot like mutual funds, but trade like stocks instead of being purchased and redeemed through a fund company at the day's closing price.
To Fabian, who edits Doug Fabian's Successful Investing, ETFs are "an idea whose time has come," as revolutionary as the car and the personal computer. He predicts massive switching from conventional funds to ETFs.
In spite of their shortcomings, mutual funds are not on the verge of extinction. They still hold $7.4-trillion in assets, compared with the $172.1-billion in ETFs, according to the Investment Company Institute. However, Fabian may be right that the growth of ETFs is an unstoppable trend. There are good reasons why ETFs are attracting attention.
Like a conventional fund, an ETF is a pool of investments, usually stocks, providing diversification with the purchase of just a few shares. For long-term investors, ETFs offer advantages of low cost and high tax efficiency. For short-term traders, they offer the advantage of being able to buy and sell at fluctuating prices throughout the trading day, with no penalties for quick redemptions. Trading techniques such as limit orders and short selling can be used.
There are now 143 ETFs, most of which trade on the American Stock Exchange, where their shares make up close to 40 percent of the daily trading volume. The oldest and most popular include QQQ, which tracks the Nasdaq 100 Index; SPY, which tracks the Standard & Poor's 500 Index and DIA, which tracks the Dow Jones Industrial Average. They are known by their nicknames: Cubes, Spiders and Diamonds. Other ETFs track various other U.S. stock indexes or stocks in a particular sector, country or region of the globe. Six track bond indexes.
All ETFs are structured as index funds, which means they are set up to mimic the performance of a particular index rather than having a manager who picks stocks hoping to beat the market. That's a big reason their costs are so low and a reason money managers like to use them in client portfolios.
The primary disadvantage for investors is the transaction cost. You can buy an ETF only through a broker, which means you have to pay a brokerage commission. For a one-time investment of a few thousand dollars or more, that's not a problem. But if you are making frequent purchases or sales, especially in small amounts, you are better off buying a conventional mutual fund tracking the same index.
The other drawback is that the price of ETF shares in a fluctuating market may differ from the value of the underlying securities. This is more of a risk with thinly traded ETFs.
The Vanguard Group, which is known for its conventional index funds, might have the most to lose from growth in ETFs. However, the company decided to capitalize on the ETF trend rather than fight it. Vanguard offers 16 of its own ETFs, known as VIPERs, and plans to introduce six more before the year is out.
Q. If I have approximately $22,000 invested in an IRA at age 46, approximately how much should the account grow over the next 20 to 30 years? How do I figure the amount?
To project the future value of an investment, you need a financial calculator, which you can find on the Internet at sites such as money.cnn.com (click on "calculators" under "financial tools"). If your account earns 6 percent a year and you never invest another dime, it will be worth $70,557 in 20 years. The bad news, as the Web site will tell you, is that it will be worth only $38,368.49 in today's dollars if inflation runs 3 percent a year.
Working with a calculator like this allows you to run all kinds of "what if" scenarios, finding out how much your account will be worth if you earn higher or lower returns, if you contribute a certain amount each month or year, or if you allow your money to continue compounding for additional years.
The problem, of course, is that no one can say for sure what future returns and inflation will be. For long-range planning, make conservative assumptions and hope for a pleasant surprise.
Helen Huntley writes about investing and markets for the Times. If you have a question about investments or personal finance, send it to On Money. We'll try to answer those we think are of greatest reader interest. All questions must be submitted in writing, but readers' names will not be published. Send questions to huntley@sptimes.com or Helen Huntley, Times, P.O. Box 1121, St. Petersburg, FL 33731.