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Investments

2002-11-01 15:46:00

Exchange traded funds

: What are the Advantages of Exchange Traded Funds?

ANSWER:  An Exchange Traded Fund (ETF) is a basket of securities that tracks an index and is listed on an exchange.  They are similar to index mutual funds in that they mirror an index, but they trade like stocks.Before addressing the features of Exchange Traded Funds, let's review some of the advantages and disadvantages of mutual funds.  Mutual funds have been an extremely popular investment vehicle for numerous reasons including: 1 ) diversification for small investments, 2) professional management, 3) liquidity,  and 4) abundant public information and track record. Moving to some of the disadvantages of mutual funds, we will start with taxes.  IRS 1099 Income forms can have a major impact on the approximately 90 million Americans who invest in taxable mutual funds.  The most recent good year for the stock market was 1999.  Morningstar data, using 3 year annualized rates of returns, for the 5 largest mutual funds as of 9/30/99, showed the tax adjusted returns ranged from 69% to 81% of pre tax returns.Most mutual funds are not managed with tax sensitivity.  Often the funds are owned inside IRAs and 401(k)s and taxes are not an issue until money is withdrawn.  But when owned in taxable accounts, taxes can be very significant.  According to a study by KPMG LLP, the difference between the pre-tax and after-tax return of the typical mutual fund is more than 2%.Between 1994 and 1999 investors in diversified U.S. stock funds lost, on average, 15% of their annual gains to taxes.  The mutual fund capital gain problem is not limited to good stock market years.  Mutual fund capital gains distributions in 2000 (not a good stock market year) of $326 billion exceeded the 1999 (a very good year for the stock market) distributions of $238 billion.  Even in 2001 (a poor stock market year) there were mutual fund capital gains distributions of $72 billion.Another significant disadvantage of mutual funds is the high internal expenses.  For actively managed large cap funds the average expense ratio is 141 basis points (1.41%) and for large cap index funds the average expense ratio is 61 basis points (.61%).End of the day pricing is another negative feature of open-ended mutual funds.  If the market is plummeting early in the day and you want out, you can make the liquidation call but your fund is liquidated at the end of the day prices.  Similarly, you could place an order to invest in a mutual fund early in the day and prices might soar during the day and you have to pay the higher, end-of-the day price.  Would you purchase a house or a car at unknown end-of-the day prices?Of course mutual funds fluctuate in value and involve risk, as do ETFs.  Both mutual funds and ETFs are investment companies registered under the Investment Company Act of 1940.  Some ETFs are structured as open-end investment companies and some are structured as unit investment trusts.ETFs which mirror stock indexes have soared in popularity in the last few years.  They have been so successful that ETFs which mirror fixed income indexes were introduced in the summer of 2002.  Why do I predict continued success for ETFs ?  They are tax efficient, have low internal charges, and other advantages.  While income dividends will still be paid, there are minimal capital gains distributions from ETFs.  They are far more tax efficient than actively managed funds, and even more tax efficient than passive (index) mutual funds.  Barclays Global Investors Services is one of the largest Exchange Traded Fund sponsors.  Their products are called iShares and there were no capital gains distributions on any domestic iShares in 2001.When investors get out of mutual funds, shares are redeemed.  Cash has to be paid out, so securities have to be sold.  Often this results in capital gains.  By contrast, when investors get out of ETFs, they are sold on the exchange and another party is buying.  There is no forced liquidation.  If there is a need for either more or less units of ETFs, institutions handle this by creating or redeeming "creation units" of ETFs.  The institutions do this with "in kind" exchanges of large amounts of securities.The internal expenses of ETFs are dramatically lower than actively managed mutual funds and even lower than index mutual funds.  Many of the ETFs have expense ratios of 20 or 25 basis points (.20% or .25%).  Since ETFs trade like a stock, you can buy or sell at specific prices and you can learn the price of a market order right away.  They can be sold short and bought on margin.  Since ETFs  are subject to commissions for buys and sells, they may not be cost effective for smaller investments.  Like mutual funds, ETFs are sold only by prospectus.As you can see from the chart below, North American Exchange Traded Funds assets have jumped from $23.4 billion at the end of 1999 to $87.7 billion at the end of 2001.Source: Amex and Barclays Global Investing, 2002