Exchange-Traded Funds

ETFs: Why Boring Isn't Bad

Exchange-traded funds—baskets of securities that trade like individual stocks—have gained popularity as a low-cost way to track specific indexes, sectors, or commodities from coal to gold. Since they don't have big marketing costs or portfolios constantly tweaked by managers, fees are low. Now, a new variant, the actively managed ETF—similar to actively managed mutual funds in trying to beat a benchmark but able to be traded throughout the day—is cropping up. Jim Wiandt, publisher of and editor of the Journal of Indexes, has followed ETFs since 1999 and advises ETF providers IndexIQ (QAI) and ETF Securities. Wiandt spoke with reporter Laura Lallos about the funds and other trends.

A handful of actively managed ETFs have come on the market, and more are in the works. Are those in the pipeline promising?
There is some great active management out there that is low-expense, intelligently run money. People in taxable accounts will get some extra tax efficiency compared with mutual funds [since the ETFs can prune the lowest cost-basis shares].

You've got PIMCO and T. Rowe Price (TROW) now, and I could see American Funds coming in. But active management is much more difficult to sell. Up to now, ETFs have largely sold themselves. There was pent-up demand for products like SPDR Gold Shares (GLD). As for an S&P 500 index that you could trade in real time, with expenses of only 10 basis points—that sold itself. Active management relies on compensation back to advisers, brokers, and distribution platforms. ETFs are moving in that direction. For example, investors can now buy some ETFs at no cost at Fidelity and Schwab (SCHW). But there is no such thing as no cost. Investors will likely pay somehow through additional expenses.

Will we start to see ETFs in 401(k)s, without commissions? If so, will they still have low expenses?
It would almost have to be that scenario. Investors putting in a few hundred dollars a month would be crushed if they paid a commission each time. And low costs are the pitch in a 401(k), where tax efficiency and the ability to trade real-time are not.

What is the most significant recent trend in the ETF world?
Before ETFs, retail investors couldn't get access to commodities at anything approaching a reasonable price. But be aware that most of these invest in futures contracts, not the commodity itself [so won't necessarily track actual commodity prices]. Remember two summers ago, when Lehman imploded and oil prices plunged? Everyone thought oil would go right back up. And it did—but there was no way to bet on it because that expectation was built into the futures market. There's no way for ETFs to invest in oil itself. They would have to store it in tankers off the coast, which would be extremely expensive, and the government probably would never allow it.

Some gold ETFs hold bullion in a vault, so they track the actual price. But these have funky issues too, because they're taxed as collectibles. Even if you hold longer than a year, you will effectively pay income tax of up to 28%.

ETFs have gotten this sexy brand name, but the best are broadly diversified with rock-bottom costs. Exciting and investing should not go together.

The Good Business Issue
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