ETF's Rival Mutual Funds
Feb. 5, 2004 -- After more than a decade, exchange-traded fundsare finally gaining mainstream acceptance, and in some cornersthey're even being touted as an alternative for mutual fundinvestors exasperated by the industry's trading scandals.
Fans of ETFs love them because they're cheap and tax efficient,and in many cases can help streamline the investing process. Butthey probably aren't the best choice for people with smallerportfolios who want to regularly add to their investments or makeshort-term trades.
Big Finish in 2003
ETFs, which are similar to index mutual funds in that they trackspecific groups of stocks, had their biggest month ever inDecember, with net inflows of $12.75 billion. Total assets for theyear were $150.98 billion, largely due to market gains, accordingto the Investment Company Institute, the fund industry's tradegroup. That's still only about 2 percent of the estimated $7.4trillion held by mutual funds, but ETFs are poised to gain agreater market share as more money managers become comfortable withthem.
The main difference between index mutual funds and ETFs is thatETFs are traded like stocks: Their share price changes throughoutthe trading day, they can be sold short and bought on margin.Traditional mutual funds are priced once a day, at the end oftrading.
Industry experts say institutional investors, who like thegreater trading flexibility, make up about half the market. Therest are purchased through advisers and brokers, and about 10percent are bought by individual investors.
"ETFs are an instrument that has sort of started to come of agein the last couple of years," said John Rea, chief economist withthe ICI. "We really need a few more years to see how it evolves… in the retail sector."
The number of ETFs ballooned from about 80 in 2000 to 133 lastmonth after The Vanguard Group raised its stake with its 14 newVIPER funds. The biggest player remains Barclays, which offers 85different ETFs, many launched through its iShares family over thelast 3½ years. The firm established its first ETF in 1996, "and for much ofthat time, our competitors have been saying these are a fad,they're for day traders," said Lee Kranefuss, chief executive ofETF products at Barclays Global Investors.
"Vanguard's action really validates our position," Kranefusssaid. "These are a low-cost, tax-efficient, transparent investmentvehicle, and that's a very compelling set of ideas."
Beware of Fees
The average expense ratio for ETFs is 0.47 percent, while theaverage for index equity mutual funds is 0.90 percent, according tofund tracker Morningstar Inc. For investors with a buy-and-holdapproach, ETFs can be more tax efficient than mutual funds, becausethey tend to have smaller capital gains.
However, paying a brokerage fee each time you buy more shares ofan ETF can get quite expensive for small investors. If you'reslowly building wealth by investing a portion of every paycheck,mutual funds are a better bargain, said Morningstar analystChristopher Traulsen.
Suppose you invested in the oldest and biggest ETF — Spiders,short for Standard & Poor's Depositary Receipts, which track theS&P 500. They have an expense ratio of 0.11 percent, meaning thatif you invested $10,000 all at once, you'd spend $11 to own it,plus whatever brokerage fees you paid to make the trade. Comparethat to the Vanguard 500 index fund, which has an expense ratio of0.18 percent. The ETF looks cheaper, right?
Imagine investing the same $10,000 over the course of a year,writing a check every month; the brokerage costs and expenses ofbuying shares of the ETF probably would add up to more than $100,but the cost of owning the similarly traded mutual fund would stillbe just $18. "If you're a dollar-cost averager, or even if you're makingjust a few trades per year, ETFs are probably not a good deal foryou," Traulsen said. "ETFs are really best suited for someone whois investing a lump sum of money for the long term, or a rapidtrader who is willing to pay the brokerage commissions."
ETFs can be great tools when used correctly. Money managers willoften "park" cash in an ETF while they're looking for a morestrategic investment. Some like knowing precisely what stocks areheld in an ETF, an edge they might not have with mutual funds. Andbecause they track specific indexes, ETFs avoid "style drift,"which happens when a mutual fund shifts from its stated approach.
"With all the stuff going on in the fund industry, ETFs are agreat option if you're looking to invest in an asset classquickly," said Thomas F. Lydon Jr., president of Global TrendsInvestments in Newport Beach, Calif. "ETFs offer greatdiversification quickly, and you know what you're buying."