|
|
Get Four
|  | MAY 5, 2004
By Amy Tsao Understanding ETFs Put off by the recent mutual-fund scandal, many investors are starting to investigate exchange-traded funds. Here's the lowdown Exchange-traded funds, in case you haven't heard, can be an efficient way to invest in the stock market. These securities mirror various benchmark indexes -- the Dow Jones industrials, the Nasdaq 100, or the Standard & Poor's 500 among them. ETFs trade like stocks on an exchange, their prices fluctuating throughout the day. That's unlike mutual funds, whose prices are set each trading day at the market's close -- a factor that was exploited in the past year's fund scandals. ETFs offer quite a few virtues compared to a host of other investment vehicles. Besides being tradable intraday, ETFs generally cost less to buy into than mutual funds and should be more tax-efficient than a fund that tracks the same index. Little wonder they've become so popular. Investment Company Institute, a trade association for mutual fund and ETF companies, figures that as of the end of March, 2004, ETFs' net assets totaled $161 billion, up from $50 billion at the end of 2000. COSTS AND CONCENTRATION. Yet, that remains a fraction of the $7 trillion invested in mutual funds. And while ETFs can be a good alternative to traditional index mutual funds, they're not risk-free or necessarily perfect for the individual investor. They're still primarily the domain of institutional investors, hedge funds, and other professionals. Barclays Global Investors' ETF division, called iShares, the dominant player in the business, figures that some 60% of its ETF customers are institutional, with most of the remaining business coming from financial advisers who have individual investors as clients. Fewer than 2% of iShares are bought by retail investors on their own. For individual investors, many of whom are accustomed to mutual funds and 401(k) savings plans, buying ETFs can seem costly. Because they trade like individual stocks, they're available primarily through brokers. That means investors have to open up a brokerage account and pay a commission each time a trade is made. For someone who's looking to contribute regularly to their ETF portfolio, as with a 401(k), it may not be worth the setup and trading costs. While companies are offering more types of investments to choose from, some ETFs such as those focused on a particular sector or country can be quite volatile. "These tend to be pretty concentrated," says Morningstar analyst Christopher Traulsen. The iShares that track the Dow Jones telecom index, for example, has 78% of its assets in its top 10 holdings, Traulsen notes, making its swings more dramatic. Other country or region-focused ETFs are often similarly concentrated. ACTIVE OR PASSIVE? ETFs that track the Nasdaq 100, called QQQs (QQQ ) and those that track the S&P 500, called Spiders (SPY ), have become well-liked among professionals. However, those are relatively stable compared to small or midcap indexes, which include many companies that will end up growing out of the indexes. "When a stock appreciates and exceeds the cutoff for the index, you have to sell it, so there's a capital gain," Traulsen says. If an investor's primary concern is tax efficiency, "make sure the benchmark [index] has relatively low turnover," he cautions. ETFs also raise another question for investors -- whether to take an active or passive approach to portfolio management. "Owning ETFs means you're fully invested with the market -- good or bad. That can present a problem," says Peter Wall, chief investment officer at Chase Personal Financial Services, who's generally an advocate of using ETFs. If an index isn't doing well, active fund managers can "go into defensive mode," Wall says. Stock-pickers may still lose money -- but possibly less than the index, he says. That potential advantage has some professional financial advisers taking baby steps into ETFs for the time being. "We recently made our first effort to use ETFs," says Tim Schlindwein, managing principal at Schlindwein Associates in Chicago. He was investing in global stocks through an international index fund but now owns an international iShares instead. For now, Schlindwein says he doesn't plan on trading the ETF intraday. "That's something we haven't quite figured out how or whether to take advantage of." MORE CHOICE. The mutual-fund scandals that continue to unravel are probably getting some investors to take a hard look at ETFs, but they're still appealing primarily to institutional investors who need to move in or out of a certain segment of the market quickly. Day-traders who once used index-focused mutual funds to hedge bets and individual investors who have a lump sum to invest will likely make up the rest of ETF investors. Certainly, ETFs serve important functions, but they're not about to overtake mutual funds any time soon. No huge marketing mechanism is at work, urging the average individual investor to jump in. They're just one more option for investors -- as long as they take the time to understand the costs and risks.  Tsao covers the markets for BusinessWeek Online and writes for the Street Wise column Edited by Beth Belton
BW MALL
SPONSORED LINKS
Get BusinessWeek directly on your desktop with our RSS feeds.
Buy a link now! Add BusinessWeek news to your Web site with our headline feed. Click to buy an e-print or reprint of a BusinessWeek or BusinessWeek Online story or video. To subscribe online to BusinessWeek magazine, please click here. Learn more, go to the BusinessWeekOnline home page  | | |
 Copyright 2004, by The McGraw-Hill Companies Inc. All rights reserved.Terms of Use | Privacy Notice |
Printer-Friendly Version
