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Exchange-Traded Funds Come of Age

Securities: The industry growth potential for index-tracking shares is uncertain.


Assets in exchange-traded funds--those index-tracking shares promoted as low-cost, easily tradable and tax-efficient alternatives to traditional mutual funds--have grown much more slowly so far this year after roughly doubling every year since 1995.

ETFs, first offered in 1993, have gained acceptance among retail and institutional investors alike. But now that most benchmark stock indexes are covered by ETF securities, some analysts wonder: Has the industry matured, and where does it go from here?

The major financial firms that created index ETFs see potential in new twists on the basic idea, including fixed-income ETFs, shares aimed at overseas investors, and even ETFs based on actively managed stock portfolios.

Proponents say the ETF industry still has tremendous growth ahead. They note that, though ETF assets have zoomed to more than $72 billion from less than $16 billion at the end of 1998, traditional mutual funds still have almost 100 times their assets.

But some say that's for good reason.

"ETFs are a strong competitor for mutual funds, but at this point not a threat," said Morningstar Inc. analyst Christopher Traulsen in Chicago. "They are an incredibly useful tool, but investors should be aware of their significant disadvantages."

Brokerage costs in buying and selling ETFs, for example, can more than wipe out the benefit of their lower management expense ratios when compared with regular index mutual funds.

Meanwhile, though actively managed ETFs could in theory give mutual funds a run for their money, the idea is no cinch to clear regulatory hurdles or attract much investor interest even if it does, analysts say.

The popularity of ETFs to date stems from what is at once their complex, yet simple, structure. ETFs track the performance of broad indexes such as the Standard & Poor's 500, the Nasdaq 100 and the Dow Jones industrial average, and also narrower market sectors such as technology, health care and real estate.

Owning an ETF, then, essentially is owning all of the stocks underlying the index on which the ETF is based.

But unlike traditional index mutual funds, ETF shares can be bought and sold throughout the day (rather than just at the close of trading). They also can be bought on credit, and sold "short" (a bet on falling prices).

Investors trade ETFs with each other, primarily via the American Stock Exchange. What is supposed to keep an individual ETF price in line with its underlying index is the process of "arbitrage": Institutional investors and brokerages can make money trading ETFs against their underlying share baskets if even small pricing disparities arise between the two.

So far, most ETFs have worked as planned. Traders like them for their flexibility and the speed with which they can be bought or sold, like any individual stock.

For long-term investors the appeal is that ETFs generally charge lower annual management expenses than comparable mutual funds, and they can be more tax efficient--meaning they pay out few, if any, annual capital gains distributions.

"Without exception, the ETF is the most effective asset-allocation tool that has been created," said Kristoph J. Rollenhagen, an analyst at Prudential Securities in New York. He noted that popular ETFs such as the "Qubes," which trade under the symbol "QQQ" and track the Nasdaq 100, and "Spiders," which trade as "SPY" and track the S&P 500, have fans ranging from small investors to big hedge funds.

The Qubes are by far the most actively traded ETF and the overall volume leader on the Amex.

Considering Transaction Costs

But investors should carefully consider transaction costs when weighing ETFs against regular funds.

Barclays Global Investors' "iShares" S&P 500 ETF, for example, charges just 9 basis points, or 0.09%, per year in expenses, compared with 18 basis points for the Vanguard 500 Index fund. But that edge of $9 per $10,000 invested could be negated by a single trading commission, Traulsen noted.

The bottom line: For "the typical buy-and-hold investor socking away $200 a month, there's no advantage" to ETFs, Traulsen said. "Their use is limited to those willing to pay up for the privilege of trading frequently or immediately, or those who make one big lump-sum investment and then refrain from trading," he said.

What's more, though most ETFs have paid out little in capital gains, many of them have short histories. And already there have been notable exceptions: Barclays' Canada and Sweden ETFs paid out massive capital gains last year, for instance--just as many traditional mutual funds did.

Regardless of their shortcomings, some investors say the convenience of ETFs makes them better choices than alternatives.

Mike Freeman, an investor in Wichita, Kan., said he uses ETFs tracking the large-cap S&P 500, the S&P mid-cap 400 and the S&P small-cap 600 as his core holdings. He likes knowing that he could quickly shift assets from his S&P 500 shares into a money market fund if he wishes.

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