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Exchange-traded funds becoming popular with investors

Updated:
By Bill Deener / The Dallas Morning News


As if day trading, online trading, after-hours trading and several thousand mutual funds weren't enough, investors now can dabble in another alluring Wall Street concoction – exchange-traded funds.

Some investors may not be familiar with ETFs, but their popularity has exploded over the last year, and money is pouring into these funds by the bucketful, according to the Financial Research Corp., a Boston research company. In fact, a few market experts have even claimed these funds might one day challenge the supremacy of traditional mutual funds.

While that's probably a stretch, the growing popularity of ETFs should at least put pressure on mutual fund companies to trim their management fees, financial experts said.

Exchange-traded funds are closely related to ordinary index mutual funds, such as the Vanguard 500 Index fund, in that they track a market benchmark such as the Nasdaq composite index or the Standard & Poor's 500.

ETFs, however, are traded throughout the day at prevailing market prices, just like stock, while ordinary mutual funds are priced only at the 3 p.m. (Dallas time) market close.

One of the most popular exchange-traded funds tracks the Nasdaq 100 index and trades under the symbol "QQQ." But there are also ETFs that track the Dow Jones industrial average, called Diamonds, funds that track the S&P index, called SPDRs, or Spiders, and a growing number of others that track smaller indexes and sectors.

"We view exchange-traded funds as the next generation of mutual funds," said Liz Kennedy, spokeswoman for State Street Global Advisors, which manages 20 ETFs, including the Spider fund. "They are taking mutual funds to a new level."

Assets held in all exchange-traded funds have grown from $15.6 billion at the end of 1999 to almost $50 billion today, according to the American Stock Exchange (Amex). And ETF assets are expected to grow to at least $445 billion by 2007.

"We believe that ETFs may turn out to be the most significant new product category of this new decade," said a recent report issued by Financial Research. "But that doesn't mean regular mutual funds will be disappearing any time soon."

Assets growing

SPDRs, which began trading in 1993, have attracted $24.19 billion in assets, the most of any ETF. But the Nasdaq 100 tracking shares, which began trading in March 1999, are closing in fast.

Assets held in QQQ shares, which are managed by the Bank of New York, have grown from $2.87 billion in 1999 to $16.78 billion today, according to the Amex, where most ETFs trade. Currently, 78 exchange-traded funds are bought and sold over the Amex, more than double the number from last year, and many more ETFs will be rolled out in the coming months.

For example, Barclays Global Investors, a unit of London-based Barclays PLC, has created 57 ETFs that will trade on the American Stock Exchange. The flagship Barclays product, iShares S&P 500 Index fund, tracks the S&P index, but it has other funds that track Internet companies, telecommunications, energy, health care and financial services.

Exchange-traded funds have struck a favorable note with investors because of their flexibility, low expenses and tax advantages, said Cliff Weber, senior vice president of product development at the Amex. They can be purchased during normal trading hours from a regular broker, or through one of the online services, such as Charles Schwab & Co. or ETrade.

Investors can buy them with borrowed money (on margin), hedge with options and futures, or even "short" ETFs, which is a bet that the underlying index will move lower, said Mr. Weber.

Low expenses

In general, exchange-traded funds carry lower expenses than traditional mutual funds, because the asset management firms, such as State Street, don't deal directly with individual investors. That means they don't have to pay for expensive retail centers.

Investors in Spiders currently pay an annual expense fee of 0.12 percent, according to Ms. Kennedy, while many ordinary mutual funds charge 1.5 percent or higher in annual fees. Additionally, ETFs generate minimal taxable capital gains because of low turnover in the underlying stock portfolio.

"Buyers and sellers of these shares trade in the secondary market away from the fund, so to speak," said Mr. Weber of Amex. "So there is no need for the fund to sell shares to meet redemptions."

And that greatly reduces capital gain distributions to investors, he said.

While all those factors might prove advantageous, investors considering ETFs for their portfolios should proceed with caution, said Henry Hu, professor of banking and finance at the University of Texas Law School. In fact, the very ease with which these shares are traded "may encourage too much trading," he said.

"If investors really insist on being in stocks, they would be better off carefully putting together a portfolio they are comfortable with and then stop obsessing over day-to-day fluctuations," Mr. Hu said.

Brokerage fees

Secondly, while annual management expenses are generally lower for these products, initial brokerage fees still will nick investors. These fees can range from $7 a trade at some of the online brokerage firms to more than $100 at a traditional brokerage house.

These costs would be insignificant for those making one large investment, but those investing a few hundred dollars each month may want to consider a no-load index mutual fund with a low annual expense ratio, Mr. Hu said.

"Many people are periodic investors and those brokerage commissions can really dig in deep into your returns," he said.

And finally, investors in exchange-traded funds – or any fund that simply tracks an index – are giving up on active management.

In other words, they are content for their funds to simply mirror a particular index without interference from managers buying and selling stocks for the fund. And that's probably fine as long as the index is a broad one such as the S&P or the Nasdaq.

But many of the newly minted ETFs are mirroring much smaller and less well-known indexes.

"Those narrow slices of the market could expose them to risks and returns that are quite different from those of the market in general." said Mr. Hu. "For instance, that narrow slice could go down while the overall market is going up."

Those concerns notwithstanding, assets in exchange-traded funds are expected to grow over the next several years at a 30 percent to 50 percent annual rate, according to Barclays. Fixed-income ETFs are expected to roll out this year and actively managed ETFs are probably not far behind.

"When mutual funds first came out, they helped investors diversify risk," said Ms. Kennedy of State Street. "Now, they still want that but they are also concerned about costs and tax efficiency."

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