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Exchange-traded funds provide an alternative to mutual funds

By Mary Ann Milbourn
The Orange County Register

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Spiders have crept into the stock market — and Vipers, too. But they're not creatures from your usual investment jungle.

They're part of a growing trend toward alternative investments called exchange-traded funds. These ETFs — which often sport exotic names such as Diamonds and Qubes — are basically baskets of many companies' shares. They mimic index mutual funds but trade like stocks.

ETFs began 10 years ago when the American Stock Exchange created Spiders — Standard & Poor's Depository Receipts, or SPDRs — a group of shares representing the 500 companies on the S&P 500 index. Their popularity has grown in recent years as more companies created new types of funds pegged to different indexes.

Now they've gained new appeal as some investors, worried about the growing mutual-fund scandal, cast about for someplace else to put their money.

About ETFs Spiders, or SPDRs — Standard and Poor's Depository Receipts. Track a variety of S&P indexes. Diamonds (ticker DIA) — Diamond Trust Shares. Track the Dow Jones industrial average. Qubes (ticker QQQ) — Track the Nasdaq 100. Vipers, or VIPERs — Vanguard Index Participation Receipts. Track several Vanguard index funds. For more information online: www.amex.com www.morningstar.com www.ici.org www.mutualfunds.about.com

"I've been telling all my friends to dump their mutual funds and invest (in ETFs)," said Bevan Strom, 66, of Laguna Woods, Calif., who has been investing in them for five years. "I don't want to rely on (a mutual-fund manager) who really has his own interests in mind rather than mine."

Other investors are getting the same idea. In 1993, $464 million was invested in ETFs, according to Strategic Insight Mutual Fund Research and Consulting. By December 2002, the figure had grown to $102 billion in all ETFs, according to the Investment Company Institute.

ETF assets rose to nearly $120 billion in September, just as the mutual-fund scandal was taking hold.

Mark Wilson, a certified financial planner at Tarbox Equity in Newport Beach, Calif., is a big proponent of ETFs, which he says have many advantages, especially for taxable accounts and investors with larger portfolios.

Like index funds, exchange-traded funds generally are inexpensive to operate since they basically are programmed to track an index. As a result, shareholders don't have to shoulder the higher fees associated with actively managed mutual funds. For example, the S&P 500 Spider has an expense ratio of 0.12 percent, or $12 for every $10,000 invested. The Vanguard S&P 500 index fund ratio is 0.18 percent, while the average no-load mutual fund's is about 1.5 percent.

Equally important for taxable accounts is that exchange-traded funds don't incur the tax liability that mutual funds run up every time they sell a stock for a gain. So, instead of mutual-fund investors' end-of-the-year surprise tax bill, ETF investors have to worry about a capital gain only when they sell ETF shares.

For short-term investors, exchange-traded funds also provide greater flexibility. Since they trade throughout the day like a stock, you know the price you will pay instead of waiting until the end of the day to learn a mutual fund's net-asset value.

There also are no restrictions on how often you buy or sell an ETF. Most mutual funds limit how often shares can be traded.

And, for investors concerned about mutual-fund wrongdoing, exchange-traded funds aren't subject to the kinds of secret market timing, self-dealing or after-hours trading that have been exposed in recent months at prominent mutual-fund families such as Janus and Putnam. An ETF's value is tied to the index it tracks and is continually visible as ETF shares are traded throughout the day.

"You can really see what's being done (with ETFs)," Wilson said.

While exchange-traded funds offer many advantages, experts say they aren't for everyone.

Investors must pay a broker a commission every time an ETF is bought or sold, so people doing a lot of trading could run up fees that would outstrip any savings. Like stocks, exchange-traded funds are also subject to the difference between the bid and ask prices. While the difference in S&P 500 ETFs' bid and ask prices is typically only a few pennies, less-popular funds can have much larger spreads — an additional hidden cost that the investor pays.

Investors also end up absorbing some costs generated by frequent trading of ETFs, which can make ETFs slightly more costly than a low-expense index mutual fund.

Wilson says brokerage fees also make exchange-traded funds less suitable for small investors. For instance, if someone invested $2,000 in an ETF with a broker's fee of $25, the fee alone would equal 1.3 percent of the total purchase.

"That could take you five or six years to get back to even," he said. Even with a discount broker, Wilson believes ETFs are still most suitable for someone with $10,000 or more to invest.

Brokerage fees also would hurt an investor who uses dollar-cost averaging to buy shares periodically.

Another potential disadvantage: In some cases, such as small-cap stocks or foreign stocks, a good mutual-fund manager may do better than an ETF or the indexes.

People whose investments are all in tax-deferred retirement accounts such as IRAs also have less reason to invest in ETFs, since one of their biggest advantages is avoiding capital-gains taxes.

And there's no guarantee an ETF will go up. If you pick an ETF based on an index that has a bad year, your ETF will go down, just like the index.

Charles Rother, president of American Strategic Capital in Los Alamitos, Calif., thinks ETFs have a place in many portfolios.

"Mutual funds are better for long-term, less active investors and ETFs are great for a very active investor," he said.

With regulators talking about imposing a 2 percent redemption fee on mutual funds to reduce trading, Rother thinks ETFs investment will grow by 10 percent to 15 percent because of their flexibility and relatively low costs.

"ETFs are a good alternative," Rother said. "But they are not a panacea."

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