June 10, 2004 Copyright © 2004, Greenwich Financial Management Inc., a registered investment advisor.  Securities offered exclusively through Purshe Kaplan Sterling Investments of Albany, NY, a NASD member firm.

Exchange Traded Funds (ETF's)

Exchange Traded Funds (ETF's) are one of the fastest growing investment products, and for good reason.

An index ETF is a type of investment company whose goal is to replicate the performance of a certain index. An index ETF invests in either all the elements of an index or a sample of the index. http://www.sec.gov/answers/etf.htm . (Another type of exchange traded fund that will not be discussed here is the Closed End Fund.)

You may be familiar with several ETF's. Some of the most well-known are summarized in the accompanying table. As you can see, the market capitalization of the most liquid ETF's is large. Major fund managers in this market include Barclays Global Investors (and its "iShares" series), State Street, Vanguard Group and Bank of New York.

Name	Ticker	Index	Mkt. Cap.	Manager	Expenses	Exchange
SPYDR's	SPY	S&P 500	$28.16 bil.	State Street	0.10%	Amex
Cubes	QQQ	Nasdaq 100	$22.08 bil.	Bank of New York	0.18%	Amex
Diamonds	DIA	Dow Jones Industrial Average	$6.03 bil.	State Street	0.12%	Amex
VIPERS	VTI	Wilshire 5000	$2.88 bil.	Vanguard	0.15%	Amex

Besides broad stock indices (domestic and foreign), ETF's also exist that track stock sub-sector, bond and commodity indices. A good reference is www.etfconnect.com .

ETF's offer several advantages over most open-end mutual funds. They generally have very low management/administrative expenses, competing effectively with even the lowest cost mutual funds in many cases. ETF's trade throughout the day, rather than providing liquidity only at the end of each day, as with most mutual funds. Unlike mutual funds, you can short most ETF's (and not have to follow the uptick rule) and you can buy them on margin. ETF's also have some disadvantages versus open-end mutual funds. There is a commission charge for each stock trade (depending on your broker's rates), unlike no-load open end mutual funds. Also, unlike mutual funds, there is a bid-offer spread that creates an implicit trading cost. See http://mutualfunds.about.com/cs/etfs/a/exchangetraded.htm . Again unlike mutual funds, ETF's are not guaranteed a redemption at the net asset value (NAV); they may trade at a premium or discount to their underlying asset value (for a small buyer, a discount could present a modest opportunity).

ETF's are generally very safe as a structure , and they are cleared by the trusted Depository Clearing Corporation (DTC), which also clears individuals stocks. Generally, too, ETF's track their index well. The real risk is the market risk posed by the behavior of the underlying index.

ETF's have an unusual feature. They don't issue shares directly to investors. Instead, they issue large blocks, called Creation Units, which are normally sold to institutional investors. These blocks may be broken up subsequently by the institutions and resold in smaller units and made available to retail investors.

There are two kinds of liquidity for ETF investors. First, they can seek to sell their shares on the exchange where the ETF trades. Second, Creation Units can be offered back to the issuer, generally in exchange for the basket of securities rather than cash.

Index ETF's are typically very tax efficient. If the elements of the index don't change, and the stocks in the index don't pay any capital gains distributions, the only tax effect might be from dividend income, and this is frequently more than offset by fund expenses. Liquidity for individual investors is provided simply by an exchange of shares in the secondary market. By contrast, in an open-end mutual fund, redemptions by others may trigger capital gains that are passed on to you.

Are ETF's suitable for you? They might be if you are a very active trader, as open- end funds increasingly have short-term redemption fees to discourage market timing. The other case, ironically, is where you are an inactive trader, perhaps using a deep discount broker, and the very low expense ratios of ETF's make up for their commission and bid-offer costs. If you buy every week or month, as part of a saving or dollar cost averaging program, the commissions will add up with ETF's, and a low cost open-end mutual fund will be a better choice. If you want to hedge your bets by shorting a market or sector, ETF's may be an excellent choice. Finally, the tax efficiency of ETF's may be appealing.

 

Andy Szabo, CFA, is Managing Director of Greenwich Financial Management Inc., a Registered Investment Advisor, which advises individuals and companies on investments, insurance and employee benefits.  Questions or comments welcome by phone at 203-531-2877 or e-mail: Szabo@GreenwichFinancial.com.