business

New Exchange Funds: Not Just Spiders And Webs

They're hybrids of stocks and indexed mutual funds

Debate rages eternally over whether it's wisest to buy and sell stocks directly or through mutual funds. But for those who want elements of each, there's a third choice: exchange-traded funds. Like stocks, the hybrids--which go by such fanciful names as Spiders, Diamonds, and WEBS--are priced throughout the day and sell in affordable denominations. But like indexed mutual funds, they expose investors to a diversified portfolio at a low cost. Currently, there are 30 exchange-traded funds. And starting early next year, a flood of new offerings is slated to hit the market. "This is the wave of the future," says Robert Shakotko, senior vice-president for index services at Standard & Poor's (like BUSINESS WEEK, a unit of The McGraw-Hill Companies), which licenses its indexes to companies developing exchange-traded products.

Most exchange-traded funds are alternatives to popular index funds. Take Spiders, which, with $13.7 billion in assets, have attracted more than half of the dollars in these instruments. A play on the acronym SPDR (for Standard & Poor's depositary receipts), Spiders invest in the same stocks as S&P 500 mutual funds. Diamonds buy the 30 stocks in the Dow Jones industrial average. And each of 17 WEBS, or World Equity Benchmark Shares, tracks a specific foreign stock index, from Mexico to Britain.

As these basic products have gained a following, the offerings have become more exotic. You can now buy an exchange-traded version of the tech-heavy Nasdaq 100 Index. Nine others track industry groups within the S&P 500, allowing investors to double up, say, on technology by marrying a tech fund to a Spider. For Net bulls who can meet an $11,000 minimum, Merrill Lynch's new Internet HOLDRs combine shares in 19 of cyberspace's largest citizens, including America Online and Yahoo!

NEW WAVE. But that's just the beginning. Next year the number of exchange-traded funds is expected to more than double as the world's largest--but perhaps least known--manager of indexed assets, Barclays Global Investors, rolls out 51 new funds. They will include broad funds, such as one covering 85% of the U.S. stock market. And despite questions about how precisely some of the less liquid indexes can be tracked, Barclays will offer a host of narrow funds focused on industries and foreign benchmarks, including the Dow Jones Internet and Real Estate indexes and the Toronto Stock Exchange 60 Index.

Still more products are likely to follow. Dow Jones and S&P say they have seen a jump in licensing inquiries. Gary Gastineau, senior vice-president at the American Stock Exchange, which is home to the 30 existing funds, predicts that exchange-traded clones of actively managed mutual funds are 18 months away. As the market expands, other exchanges are expected to vie for a slice of the Amex' monopoly. Indeed, Barclays has yet to announce where it will list its flotilla of funds.

The reason for all the activity is the flood of cash these funds have attracted. Assets in Spiders, Diamonds, and the others more than doubled since June, 1998, to $22.5 billion. "Everyone suddenly sees that exchange-traded funds are a nice way to get around some of mutual funds' complications," says James Branscome, who oversees S&P's index operations.

Indeed, the funds can be traded more flexibly than mutual funds, giving them an edge with day traders. Whereas mutual-fund shares are priced daily, exchange-traded funds' minute-by-minute fluctuations are on the ticker. Investors can also purchase options on them, buy them on margin, and place limit orders specifying the price they wish to pay. Like stocks, these funds can be sold short. This allows investors to bet against indexes by selling borrowed shares in the hope of replacing them at a profit after prices fall.

Long-term investors can also benefit. While many mutual funds require minimums of $2,500 and up, many exchange-traded shares trade for as little as $100.

They are also more tax efficient than even the most tax-friendly mutual funds. Take the Vanguard Group's 500 Index Fund. If the S&P 500 were to fall by 20%, prompting 44% or more of the fund to be redeemed, Vanguard figures it would be forced to sell low-priced stock. Remaining shareholders would then be stuck paying taxes on those capital gains. Accordingly, in a bear market, the fund might have no choice but to pass along some of the $42.77 per share it currently has built up in unrealized gains---a figure equivalent to 36% of its assets.

In contrast, exchange-traded funds are protected from selling low-priced stock to meet outflows. Instead of redeeming shares directly, shareholders buy and sell on the secondary market. Investors who cash out pay taxes on gains, but they avoid surprise tax bills.

Be aware that Spiders and their descendants have drawbacks. Although costs are generally low and competitive with comparable index mutual funds, such as the Vanguard 500 Index Fund with an expense ratio of 0.18% (table), investors must pay brokerage commissions. Even at discount and online brokers, these fees can add up for frequent traders. Spiders, Diamonds, and Nasdaq 100 funds are also unable to reinvest dividends more frequently than once a quarter, causing performance to lag in a rising market. That's why Vanguard's S&P 500 fund beat the Spider by an average of 0.16% a year over the five years ended in 1998. The new Barclays funds' structure will rectify this defect.

BEAR MARKETS. Perhaps the biggest question is how the instruments will perform in a sell-off. Like closed-end mutual funds, exchange-traded funds don't always trade for net asset value. Still, for Spiders and Diamonds, deviations have been minor--a maximum of about 1% so far, a Barclays filing with the Securities & Exchange Commission says. Some WEBS, though, have diverged from their indexes by as much as 10%, largely the result of SEC and Internal Revenue Service regulations that prevent mutual funds from concentrating as much as some foreign benchmarks in a single stock. Thanks to Malaysia's imposition of capital controls last year, the gap for its WEBS was a huge 18.9% for the year ended last August.

Fans say the funds are unlikely ever to stray far from their indexes. That's because arbitrageurs are constantly looking to profit from price discrepancies. But Frank Stanton, editorial analyst at Morningstar.com, the fund tracker's Web site, cautions that in a market swoon, funds that follow less liquid indexes may have trouble.

Despite these caveats, exchange-traded funds' advantages are hard to deny. So whether you want to buy and hold a broad market index or day-trade one industry, don't overlook this new wave of investments, which combines some of the best features of stocks and mutual funds.

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