By Andrew Leckey
The mutual fund scandal encouraged some wary investors to forage for new investment opportunities.
One alternative that's attracted their attention is the exchange-traded fund, or ETF. It's similar to an index-tracking mutual fund but trades like a stock.
A total of $252 billion is now invested in more than 170 different ETF vehicles tied to various indexes, a dramatic 47 percent increase in assets from a year ago. That's still a far cry from the nearly $8.5 trillion in mutual funds, however.
You can buy ETFs on an exchange through a broker and sell them on the open market or redeem them for the underlying securities. The fact that they are exchange traded throughout the day differs from traditional mutual funds, whose prices are set once daily. ETFs also can have lower expenses than mutual funds.
Launched in 1993, the first ETF was the Standard & Poor's Depositary Receipt, or SPDR, which tracks the S&P 500 index. That initial "Spider" now has $47 billion in assets.
Meanwhile, Nasdaq 100 Trust Shares, which have a QQQQ ticker symbol and are known as "Cubes," invest in the largest non-financial companies on the Nasdaq stock market. They rank second with nearly $20 billion.
Barclays Global Investors popularized this field with its iShares. Major players such as Vanguard Group with its VIPERs class embraced the concept. Lately, newer firms such as PowerShares Capital Management LLC entered the fray with extensive ETF lineups.
Reflecting recent market trends, the best-performing ETFs of 2005 are those that invest in various indexes tied to energy or emerging markets.
Energy Select SPDR (ticker symbol XLE) is up roughly 42 percent this year; Vanguard Energy VIPERs (VDE) is up 41 percent; iShares Dow Jones U.S. Energy (IYE) up 37 percent; iShares S&P Latin America 40 Index (ILF) up 37 percent; and iShares S&P Global Energy Sector (IXC) is up 35 percent.
Total returns vary among similar-sounding ETFs based on the particular index chosen, how the fund replicates it, its efficiency, limits on how much of one stock position it can own and whether it includes foreign holdings.
"One reason people are turning to ETFs over mutual funds is that in a well-run ETF there should never be a capital gains dividend," said Gary Gastineau, principal with ETF Consultants in Summit, N.J., and former managing director for ETF product development at Nuveen Investments. "Investors don't pay capital gains until they sell their shares."
In traditional mutual funds, market timers make everything more expensive because of the liquidity that's required for a fund to accommodate their active trading. ETF investors don't have to bear this burden.
"Compared to mutual funds, ETFs have built-in protection because their shares are traded on an exchange between other investors," explained Dan Culloton, senior analyst with Morningstar Inc. in Chicago. "Another investor who is market timing wouldn't dilute your results since the ETF's manager doesn't have to sell securities or hold cash to meet redemptions."
ETFs, like index funds in general, tend to have greater tax benefits because they generate fewer capital gains due to low portfolio turnover.
But because of the commissions on their transactions, ETFs are not a good choice for an someone making small regular investments. Mutual funds are a more economical choice for that purpose.
"The biggest disadvantage of ETFs is that they're boring," said Harold Evensky, chairman of Evensky & Katz in Coral Gables, FL, which has $500 million under advisement and specializes in ETFs. "Average investors want to feel they can beat the market, but need to remember that investing really should be long-term and boring."
Nearly half of Evensky's equity allocation is currently in the iShares Russell 3000 (IWV), with a return of 4 percent this year, because it "provides the U.S. economy lock, stock and barrel." He also likes iShares S&P Midcap 400/BARRA Value (IJJ), up 11 percent this year.
Find an efficient index in a well-managed ETF, Gastineau stressed. He particularly likes streetTRACKS Total Market ETF (TMW), up 4 percent this year, which is based on the Dow Jones Wilshire 5000.
For average investors, an ETF will likely be a buy-and-hold core investment in a broad index that's less expensive than a comparable index mutual fund. The rest of their portfolio may be actively managed mutual funds.
The largest ETFs ranked by assets, according to Morningstar, are:
• SPDRs (ticker symbol SPY), large-capitalization growth and value stocks; up 4 percent this year, $47 billion in assets.
- Nasdaq 100 Trust Shares (QQQQ), large growth stocks; down 1 percent this year, nearly $20 billion.
- iShares MSCI EAFE Index Fund (EFA), foreign large-cap growth and value stocks, up 8 percent this year; $19 billion.
- iShares S&P 500 Index (IVV), large-cap growth and value stocks; up 4 percent this year; $13 billion.
- MidCap SPDRs (MDY), mid-cap growth and value stocks; up 9 percent this year; $8 billion.
Future ETF growth is expected in fixed income, metals and commodities. There may be actively managed ETFs ahead as well. The number of hedge funds investing in U.S. exchange-traded ETFs expanded by 72 percent over the past year, according to research by Morgan Stanley, while institutional investors using them rose 11 percent.
"There are so many ETF choices that there's a temptation to play sectors, regions and esoteric asset classes, which spells trouble for the average investor," Culloton said. "History has shown investors use sector funds poorly and are better off with long-term investing."
Editor's Note: Andrew Leckey's column, "Successful Investing," appears regularly in The Bull & Bear Financial Report.
