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An exchange traded fund, or ETF, is a popular investment with both institutional and individual investors.

ETFs are similar to mutual funds but with some unique differences. John Doe purchases or sells mutual fund shares directly from the mutual fund based on its net asset value at the end of the day. Just like stocks, Mr. Doe requests his broker to purchase or sell shares of an ETF, which trade on a stock exchange at any time during the business day at the then current market price. Trading techniques such as using limit orders, buying on margin and selling short are available. An ETF seeks to track the performance of a specific stock or bond market index. Stock indexes include large-cap United States indexes, small-cap indexes, international indexes and many others. When you buy shares of an ETF, you own an interest in a basket of stocks — a quick and easy way to diversify. Ten years ago, ETFs were just beginning. Today, more than $350 billion is invested in more than 230 ETFs.

ETFs do not sell individual shares directly to their investors. Instead, ETFs only create or redeem their shares in large blocks (blocks of 50,000 shares, for example) that are known as "creation units" — primarily with large financial institutions. For example, a financial institution in a like-kind, nontaxable transaction will exchange a basket of its securities that generally mirrors the ETF's portfolio for a creation unit. Each creation unit represents a financial interest in a specified number of shares (say 50,000) in the ETF's fund. Redemptions are just the opposite. The manager of an ETF seeks to have the supply of ETF shares outstanding in line with its demand to help the ETF trade close to its net asset value.

Creating or redeeming ETF shares as described above benefits the investor by making ETFs very tax efficient and by keeping ETFs trading at prices close to their net asset values.



Advantages of ETFs over

Vanguard index mutual funds

1. Tax efficiency: Normally, the only time an ETF manager needs to purchase or sell shares within its fund is when its underlining index changes (for example when WorldCom was dropped from the S&P 500 index). That is why ETFs have limited capital gains to distribute.

2. Fewer trading restrictions: Mutual funds may require a minimum initial investment of $2500 or more and are only traded at the end of the day at net asset value. Some mutual funds have front-end sales charges and back-end charges if you sell them too soon. ETFs have none of these restrictions.

3. Greater Choices: There are ETFs that mimic numerous equity indexes including those tracking large, mid and small-cap stocks; growth and value stocks and tracking stocks in specific countries, regions, sectors, industries, real estate and other niches of the market. Also, ETFs track specific bond market indexes including the short, intermediate and long-term bonds. Vanguard's mutual funds do not provide this wide array of choices.



Disadvantages of ETFs

1. Trading costs: Each time you buy or sell an ETF, you will pay a brokerage commission and bear the cost of the bid/ask spread (which can range from .09 percent to much higher). In a thinly traded market, you could buy the ETF for more, or sell it for less, than its true net asset value.

2. Liquidity Concerns: In less efficient markets, it may take time to match an ETF seller with a buyer.

3. Lower Costs: Vanguard is the granddaddy of index mutual funds and a low-cost provider. Comparing operating expenses of Vanguard's stock funds requiring a $100,000 minimum investment against Barclay's iShares with no minimum investment shows respective operating expenses of a large-cap index (.09 percent versus .09 percent), small-cap index (.13 percent versus .20 percent), European index (.18 percent versus .60 percent) and financial services index (.28 percent versus .48 percent). (Operating expenses of Vanguard's ETFs are slightly lower than that of its mutual funds.)



Who should use ETFs?

They include: (a) long-term, buy-and-hold investor seeking core holdings that provide broad market exposure while minimizing trading costs and taxable income; (b) market timer seeking to capitalize on perceived short-term opportunities without incurring mutual fund redemption fees; (c) someone seeking to increase or decrease exposure in selective market areas.



Who should not use ETFs?

They include: (a) investors who frequently trade their ETF holdings since commissions and other trading costs will dampen returns; (b) those making monthly or frequent capital investments or withdrawals from their funds; (c) investors with a small amount to invest since trading costs will be a sizable chunk of their outlay.

Conclusion: ETFs have unique advantages and are important products for an investor to use, when appropriate.

Next month: Who are CFAs and CFPs?



Roger E. Muns, CFA and CPA, of Wealth Management, LLC, in Jackson, is president of Chartered Financial Analysts® (CFA) Society of Mississippi.




February 2007

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